FEDERAL INSTITUTIONS AND THE DEMOCRATIC TRANSITION: Learning from South Africa

by

Robert P. Inman and Daniel L. Rubinfeld

Draft: May 15, 2006

ABSTRACT

We present a political economy model of a peaceful transition from autocracy to democracy,motivated by, and calibrated to, South Africa at the time of its own successful transitionfrom white, elite rule under apartheid to today’s multi-racial democracy. The primarybarrier faced by South Africa in its transition is symptomatic of a central barrier to peacefultransitions generally: How can the emerging majority credibly promise not to economicallyexploit the once ruling elite? South Africa found its answer in a “democratic federalism”constitutional system. The constitution creates an annual policy game where the newmajority and the old elite each credibly control one policy instrument (fiscal policy) ofcentral importance to the other. The majority-controlled central government controlsgeneral tax policy, while provinces, at least one of which is politically controlled by the oldelite, are assigned responsibility for providing important redistributive services. In effect,the federal constitution creates a policy “hostage game” between the new majority and theold elite in which each can check policy abuses by the other. We show that for plausiblespecifications of the political economy, this annual policy game has a stable, less-than-fullyexploitative stationary equilibrium that the elite may prefer to current autocratic rule. Themodel is calibrated to the South African political economy at the time of its transition and“predicts” the actual structure of redistributive fiscal policy now in place. Between formsof democracies, the federal regime is preferred to unitary governance by both the elite andthe new ANC majority. At the time of the transition, this federal democracy is shown to beunambiguously preferred to autocracy by the then oppressed majority and conditionallypreferred by the then ruling elite. For the elite, the move to democracy means higher taxrates but also higher rates of economic growth; democracy will be preferred to apartheid,if the elite’s (real) rate of time preference is less than their rate of return from the transition.

Robert P. Inman is the Richard K. Mellon Professor, Finance and Economics, the Wharton School,University of Pennsylvania, Philadelphia, PA 19104, inman@wharton.upenn.edu

Daniel L. Rubinfeld is the Robert L. Bridges Professor of Law and Professor of Economics, University ofCalifornia, Berkeley, CA 94720, rubinfeld@law.berkeley.edu

The work here has benefitted significantly from comments by seminar participants at Berkeley, Cornell,NYU, and Penn. Particular thanks are due to Carolyn Ballay, Grant Long, and Jon Stott for extraordinarilyvaluable research assistance.

1 On democracy and economic growth see the debate between Acemoglu, Johnson, and Robinson (2001) and

Glaeser, et. al. (2004). On democracy as an institution to promote economic fairness and personal liberties, see Dreze

and Sen (1989), Rodrik (1999), and Shleifer et. al. (2004). For evidence on democracy and political participation, see

Verba and Nie (1972), Frey and Stutzer (2000).

2 On democracy and war, see Bueno de Mesquita, et. al. (1999). On democracy and trade, see Mansfield,

Milner, and Rosendorff (2002).

2

What if the poor, on the ground of their being a majority, proceed to divide amongthemselves the possessions of the wealthy – will not this be unjust? . . . (We may reply inreturn) . . . Whenever a majority of any sort, irrespective of wealth or poverty, dividesamong its members the possessions of a minority, that majority is obviously ruining thestate. Aristotle, The Politics of Aristotle, Ernest Barker (ed.), p. 122.

Poverty is the cause of the defects of democracy. This the reason why measures should betaken to ensure a permanent level of prosperity. This in the interest of all classes, includingthe prosperous themselves; and therefore the proper policy is to accumulate any surplusrevenue in a fund, and then to distribute this fund in block grants to the poor. Aristotle, ThePolitics of Aristotle, Ernest Barker (ed.), p. 269.

I. Introduction

Democratic governance is clearly preferable to its alternative, autocratic rule. While the importance

of democracy as a pre-condition for improved economic growth remains an open research question, there is

little doubt that stable democratic institutions provide basic protections for essential human and economic

rights and opportunities to participate, both directly and indirectly, in the management of societal affairs.1

There appear to be significant international advantages to stable democracies as well. Democracies are less

likely to initiate international aggressions and more likely to support free trade agreements.2 Given the case

for democratic rule, the issue then becomes how best to facilitate the transition from autocracy to democracy.

The paper presents a model of the political economy of democratic transition. The motivation is

drawn from the recent history of South Africa’s successful (to this point) transition from a white, elite

autocracy to a multi-racial, majority-rule democracy, as described very briefly in Section II. As Aristotle

stressed in The Politics, the barriers faced by South Africa in its move to democracy are symptomatic of

transitions barriers generally. The barriers arise because the once oppressed majority that is destined to

dominate democratic national politics may not be able to credibly promise the current ruling elites that they

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will not be economically exploited in the new regime. If there are not sufficient guarantees and the current

elites have military power, they may opt to resist rather than support the transition.

The challenge is to find a democratic constitution that can credibly offers such protections. Section

III responds to this challenge by showing that under well-defined conditions a federal constitution – defined

as system of government in which a nationally elected central government and locally elected provincial

governments each hold significant fiscal powers for the financing and provision of essential public services

– can credibly provide the needed economic protections. With a federal constitution in place, the transition

to democracy can work, even when the unitary form of governance – rule by a single national majority –

might fail to facilitate the transition.

The formal analysis is then applied to understand South Africa’s own peaceful transition to

democracy. In Section IV, we find that democratic federalism offers a sustainable and amendment-proof

constitution for the new South Africa. Section V shows the resulting federal constitution was the

economically preferred alternative at the time of South Africa’s transition, both for the country’s new

majority and for a majority of the country’s once ruling elite as well. Section VI concludes, placing this work

within the wider study of endogenous institutions.

II. South Africa’s Transition: A Brief History

The more than forty years of apartheid rule in South Africa began in 1948 with the election of the

white National Party (NP) to run the national government. In August, 1962 Nelson Mandela and other

opposition African National Congress (ANC) leaders were arrested. By the fall of 1986, it was apparent to

the moderate leadership in both the National Party and the ANC that, after years of violent conflicts,

negotiations towards full South African democracy was the only way forward. In September 1989, having

to choose among the alternatives of renewed repression and possible war or the status quo or a move towards

compromise and a democratic South Africa, NP leader F.W. De Klerk found the latter alternative the most

3 Waldmeir (1997, p. 137).

4 Waldmeir (1997, p . 228).

5 Muthien and Khosa (1998).

6 Waldmeir (1997, pp. 242-250).

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attractive.3 As a condition for majority Black rule, de Klerk and the National Party insisted on constitutional

protections for the civil liberties and property of the white minority.

Following negotiations that began in earnest in 1990 the ANC accepted in principle a constitutional

bill of rights that protected individual civil and property rights. Lacking a sufficient number of adequately

trained Black civil servants, the ANC also accepted the National Party’s demand to employ current white

bureaucrats.4 More problematic was the need to ensure private ownership of firms and to prevent excessively

high redistributive taxes.

The National Party proposed the devolution of taxing and spending powers to nine provincial

governments, at least two of which would be controlled by the NP. The ANC in turn proposed four

provinces, with all taxing powers centralized and all provinces effectively controlled by an ANC majority.5

At this point a third party entered the constitutional negotiations: the Inkatha Freedom Party (IFP)

representing the Zulu nation, led by Chief Mangosuthu Buthelezi. Chief Buthelezi demanded an Inkata-

controlled province containing the historic lands of the Zulu nation to be called KwaZulu-Natal, and the

devolution of significant spending powers to the provinces.6 The commitment of significant governmental

transfers to the provinces was crucial for Buthelezi, since this would maintain the lucrative homeland

payments he had enjoyed under apartheid. Given the NP’s ability to sustain apartheid and Inkatha’s threat

to boycott the planned 1994 elections, the ANC agreed in principle to the NP’s and the IFP’s demands for

nine provinces with significant spending responsibilities and sizeable central government transfers.

The interim constitution signed in the winter of 1994 codified this in principle agreement, but

decisions as to how to actually assign taxing and spending powers and the level of intergovernmental

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transfers were postponed until after the 1994 election. By any measure, the election was a success. Voting

was completed without incident. Nelson Mandela was elected President and the ANC won 62.7 percent of

the national vote. The National Party polled 20.4 percent nationally, but as planned, the NP won a majority

of provincial legislative seats in the new province of the Western Cape with 53 percent of the provincial vote.

Similarly, and as planned, Chief Buthelezi and the Inkatha Freedom Party won 51 percent of the provincial

vote in KwaZulu-Natal. Unexpectedly, however, the rural (white farmer) Northern Cape fell to the ANC in

a close election. The six remaining provinces went decisively to the ANC.

With elections completed, attention turned to drafting a final constitution. The interim constitution

created a Financial and Fiscal Commission (FFC) charged with the task of assigning tax and spending

responsibilities to the national and provincial governments and designing a formula for intergovernmental

transfers capable of ensuring adequate funding for provincial government services. The composition of the

Commission was equally divided between ANC and NP representation, with two additional representatives

from KwaZulu-Natal. The Commission proposed an assignment of all important taxing powers to the central

government, but delivery and spending responsibility for important redistributive services – K-12 education,

primary health care, and social security (welfare) – became the responsibility of the new provinces. Without

taxing powers, however, funding for these redistributive services required centrally decided

intergovernmental transfers. The Commission’s recommendations were incorporated into the final

constitution, which was unanimously approved on October 11, 1996.

Though the exact details of the final constitution – namely the size of provinces, their exact

responsibilities, and the final level of intergovernmental transfers – apply only to South Africa, we argue that

the constitution’s fundamental features – provinces, shared responsibilities, and transfers – apply more

broadly. Section III offers a general argument for federalism as a constitutional form to facilitate the

democratic transition. Sections IV and V then show how the South African constitution stands as an

application of our central proposition.

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III. Federal Institutions and the Democratic Transition

A. Overview: This section specifies the conditions under which an appropriately designed federal

constitution might facilitate the peaceful transition from autocracy to democracy. The underlying model is

a sequential game with two stages. In the first constitutional stage, a constitution is chosen requiring the

joint approval of both the elite minority and the poor majority – that is, both parties have a veto over the new

constitution. The constitution can specify either a unitary, or fully centralized, democracy with a single

national democratic government setting all policies, or a federal, or partially decentralized, democracy where

policy responsibilities are shared between the national government and constitutionally created provinces.

In the case of a federal democracy, the constitution will specify provincial boundaries, also assign tax,

spending, and regulatory responsibilities between central and provincial governments and perhaps set a

minimal level of service provision that each province must provide. If no, or minimal, taxing powers are

given to the provinces, then the constitution must allow for intergovernmental transfers from central

government revenues to the provinces. Both unitary and federal constitutions will allow amendments,

subject to approval by a constitutionally required (possibly, super-) majority.

In the second policy stage, the parties play an annual policy game in which the central government

controlled by the poor majority chooses tax rates, spending, and regulations and, in a federal democracy, a

level of intergovernmental transfers (possibly zero) to the provinces. Provincial governments are elected by

a majority of residents in each province; some provinces may be politically controlled by the once ruling

elite. Provinces then allocate their resources to their constitutionally-assigned responsibilities. Elite-run

provinces may choose to meet, or not, their constitutional responsibilities. In particular, the elite may

allocate some of their assigned intergovernmental transfers meant for redistributive services to elite services

or to elite tax relief, allocations we call “elite capture.” Elite capture is not possible in unitary democracies.

The sequential game is solved through backward induction. The second-stage policy game is

specified for fiscal policies, in particular, the financing and provision of redistributive (targeted) goods and

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services – for example, education, health care, housing, land reform, and income transfers. When solving the

policy game under unitary democracy, policies will be set a nationally elected poor majority so as to

maximize the welfare of a typical majority citizen. The majority will impose a national tax on the once

ruling minority elite, the proceeds of which will be allocated to provide redistributive services and transfers

to the poor majority through a national bureaucracy. The tax on the elite can be interpreted broadly as a tax

on labor income, capital, firm profits (in the extreme, nationalization), or land (in the extreme, land

expropriation). In response to national taxation, the elite are free to leave the country and take all their

human capital with them plus any of their capital income or land rents the constitution allows. Given elite

mobility, there will be an elite tax rate which maximizes redistributive revenues. We assume that the

majority will choose this revenue maximizing, fully exploitative, tax rate under unitary democracy. It is this

possibility that discourages the elite from embracing unitary democracy.

In the case of a federal constitution, the second stage policy game has the central government, again

controlled by the poor majority, setting the national tax rate with the proceeds allocated in whole or in part

to intergovernmental transfers to the provinces. Provincial governments, some of which are politically

controlled by the old elite, will then allocate their revenues to constitutionally assigned redistributive services

or to elite-only services via elite capture. Given the fact of elite capture, the poor majority will prefer unitary

democracy unless there is some compensating reason to use provinces as providers of redistributive services.

In our model there is. Elite residents are the efficient providers of such services, but these efficiencies are

only available in elite-run provinces; in majority-run provinces or under unitary democracy, elite providers

take their talents as teachers, doctors, nurses, and contractors to the private sector – or they leave the country.

It is useful to distinguish two versions of federal democracy. The first, democratic federalism, has

the central government set its national tax rate at less than the fully exploitative, revenue-maximizing tax

rate. The second, administrative federalism, has the central government set the national tax rate at the

revenue-maximizing tax rate, but continue to allocate the proceeds of that tax to provinces as

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intergovernmental transfers. Under administrative federalism, provinces are still valuable to the ruling poor

majority as low cost providers of redistributive services, at least in the elite-run provinces. Even though

national redistributive tax rates are maximal, elite residents prefer administrative federalism to unitary

democracy since elite capture is still possible. Of course, the elite’s first choice would be democratic

federalism where national tax rates are below maximal tax rates and elite capture is also possible. Which

form of federalism actually obtains is decided by the poor majority and is an endogenous outcome of the

second-stage policy game.

Only constitutions which are sustainable (i.e., self-enforcing) in the second-stage policy game will

be considered by the ruling elite and the future poor majority as credible constitutions when playing the first-

stage constitutional game. Given the assumption below that the elite loses control of the army with the

transition, the unitary constitution is always sustainable. We therefore focus our attention on finding a

sustainable federal constitution which we specify along two, or perhaps, three dimensions. The first

dimension is provincial borders, specified here by the share of the majority population (:) initially assigned

to live with elite residents in what we will call the “elite province(s).” The second dimension is the

constitutional assignment of provincial service responsibilities. At a minimum, assignment specifies the

services that provinces must provide. For this paper, we index assigned services by a parameter 8 which

measures how important assigned services are for majority resident welfare; K-12 education has a high 8

while street lighting has a relatively low 8. Constitutional assignment might also include a third dimension,

one that specifies a level of productive inputs per majority resident (q) to produce the assigned services – for

example, many U.S. state constitutions specify a minimal level of educational spending which all local school

districts must provide. The first-stage then selects a preferred constitution – values of :, 8, and perhaps q

– from among the set of all possible values of (:, 8, q) that generate politically sustainable constitutions.

Six assumptions underlie the analysis. First, the poor majority bears sufficiently large costs in lost

economic and democratic rights under autocracy that it prefers any democratic constitution, whether unitary

7 This redistributive national tax rate should be interpreted as the incremental national tax rate paid in addition

to all other taxes used to fund such pure public goods as national defense, pub lic infrastructure, and domestic security.

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or federal, to autocracy. Second, the oppressed majority does not have sufficient military strength to defeat

the current autocratic regime and to then unilaterally impose a constitution. Thus, the majority and the ruling

elite must both agree to a new democratic constitution; otherwise the autocratic regime and all associated

conflicts and costs will remain. Third, once a democratic constitution is in place, the current ruling elite

turns over control of its military to the new majority. As a result, neither elite secession nor a military coup

d’état restoring the elite to power is possible. Fourth, the civil and political rights of the elite will be

protected in the democratic regime; those not convicted of crimes against humanity during autocracy will

be able to exit the country if they so choose. Fifth, the majority and the elite are fully informed as they

negotiate the transition to democracy. Sixth, negotiators for the elite and the majority wish to negotiate a

constitution which best protects the long-run (dynastic) interests of their average constituents.

B. The Annual Policy Game: In a democratic economy, each of the M “poor” majority residents

earn W a year, while each of the N “elite” residents earn Y > W. Initially, there are N0 elite residents who

are free to leave the country, and may choose to do so depending on the tax rate imposed by the ruling

majority. Elite residents pay a nationally chosen per-capita tax, J, with the proceeds redistributed to majority

residents only as a per capita grant, b, and/or as inputs q to provide majority-valued public goods.7 If

allowed, provincial taxes are used to finance private goods and are thus treated for simplicity as an

expenditure paid for from each province’s residents’ “after-redistributive-tax-and-transfer” incomes.

Given the possibility of exit, the equilibrium number of elite taxpaying residents depends not only

on the initial elite population, but also the redistributive tax burden per elite resident. For simplicity we

combine the elite’s two responses to high taxation, leaving the country or curtailing taxable activities, into

8 A more general specification might define redistributive revenues as JAN(J)AY(J), where population is

specified by N(J) = n0 - n1AJ and taxable income by Y(J) = Y0 - RAJ; see Haughwout, et. al. (2004) for estimates of N(J)

and Gruber and Saiz (2002) for estimates of Y(J).

9 To ease notation, we assume a common wage across all public employees regardless of skill level. The

common wage assumption could be justified by simply assuming all public employees face the same private market

alternative, that is, observed employee skill differentials are unique to providing redistributive public services. Separate

wages for the three sets of workers could be allowed as long as there remains a public sector cost advantage to using elite

employees.

10 se(q) = S@(X/M) = SA(q/ae) using elite providers; sm(q) = S@(q/am) using majority providers; and su(q) = S@(q/au)

using untrained providers.

10

a single relationship of the form: N(J) = N0 - $J.8 Aggregate redistributive tax revenues are given by JN(J)

= N0J - $J2, implying a redistribution maximizing tax rate of JU = N0/2$, the rate that will be chosen under

unitary democracies.

Revenues raised from redistributive taxation will be allocated to provide public services and a per-

capita basic grant. The constitution will require a common and uniform level of public services inputs q to

be provided to all majority residents specified as q = a(X/M) where (X/M) is public employees (X) per

majority resident (M) and a is employee productivity measured by years of training. There are three classes

of public employees: elite providers with ae years of training, majority providers with am years of training,

and untrained majority providers with au years of training, where, ae > am > au. The input bundle then

provides assigned public services to the typical majority resident specified as L = L(q); we assume LN(q) >

0 and LO(q) < 0.

The central government is assumed to mandate a common civil service wage S paid equally to all

public employees.9 The cost per majority resident of providing the common input bundle q is s(q), which

is inversely related to worker training: se(q) < sm(q) < su(q).10 The central government’s budget constraint is

specified generally as:

s(q) + b = g(J) = [JN(J) - Z]/M,

where g(J) is aggregate redistributive spending available for each majority resident, and Z > 0 is a payment

to any special interest groups initially capable of blocking the transition. Z < 0 can be interpreted as

11 Specifically, sU(q) = mAsm(q) + (1 - m)Asu(q), where m is the share of majority residents serviced by trained

majority providers. We are assuming either that well-trained, elite public providers choose not to provide redistributive

services under a majority-run unitary democracy, or if they do, they are no more productive than the average majority

provider, perhaps allocating a portion of their work day to private clinics and schools for elite residents.

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international aid, where such assistance allows higher grants and services for the new majority and lower

taxes on the elite, both of which facilitate transition.

Under unitary democracies, redistributive taxes are raised centrally, the special interest payment is

made, and funds are then distributed by a central government bureaucracy directly to the majority citizens,

first through the central government’s provision of valued services and then via the per-capita grant. The cost

of providing q using a single unitary government, sU(q), is a weighted average of the cost associated with

trained and untrained providers.11 The redistributive grant to each majority resident under unitary democracy

will be b = g(J) - sU(q). Institutionally, unitary democracies can be established directly by the constitution

(no provinces) or exist de facto under a federal constitution by simply allowing the central government to

establish a separate bureaucracy using majority providers and sending no grant monies to the provinces. In

the de facto case, provinces exist in name only.

Under federal democracies, redistributive taxes are raised centrally, the special interest payment is

made, and all remaining funds are distributed as a uniform intergovernmental transfer of g(J) per majority

resident from the central government to the provinces. From this uniform grant, provinces must provide

assigned services, after which all remaining funds are distributed by the province as a per-majority person

grant. Residents in majority provinces receive their public service input bundle at a cost of sm(q) and a basic

grant b = g(J) - sm(q). Majority residents residing in an elite controlled province will also be given q, now

provided by elite public employees, at a cost of se(q), and in principle, a basic grant of b = g(J) - se(q). The

input bundle q is uniform across all provinces, set either at the constitutional stage (“exogenous q”) or, if

outside enforcement is not possible, then chosen by the majority controlled central government (“endogenous

q”). If they wish, we assume the majority can costlessly enforce q in both majority and elite controlled

12 The upper bound on n is set by the exit options of majority residents in the elite province. Majority residents

will receive W + (g - sm(q)) + 8AL(q) in a majority run province, where 8AL(q) is the utility value of the assigned services.

Majority residents in an elite province will receive W + (1 - n)[g - se(q)] + 8AL(q) + E, where E is the saved costs of exit,

or equivalently, the majority resident’s amenity value of living in the elite province. The value of n which leaves the

majority resident just indifferent between staying or leaving will define nH :

n # nH = ([E + (sm(q) - se(q))]/[g - se(q)] # 1.

The maximum rate of capture is 1. Elite provinces with high exit costs or strong majority attachment and efficient public

service provision will have high rates of elite capture.

13 There is an extensive literature estimating “fungibility” (n > 0) of intergovernmental transfers where money

intended for lower income recipients is channeled into middle class services; see, for example, Duggan (2000) and

Gordon (2004).

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provinces.

What the central government cannot control is how the elite province spends it basic grant: b = g(J) -

se(q). Elite provinces may re-allocate some of the basic grant from majority to elite residents, most likely

through the provision of provincial services (roads, parks, security) in elite residential neighborhoods. The

basic grant actually received by majority residents in elite provinces will therefore be (1 - n)[g(J) - se(q)],

where n is the rate of capture by the elite. The rate of capture will be one of two values: nL and nH. The

lower value (nL) is set by the ability of the majority residents in the elite province to organize costly protests

when capture is observed, perhaps by observing service inequities between elite and majority neighborhoods.

Once organized, these protests are assumed to impose a cost D on each elite resident. The elite provincial

leadership will therefore push n to the point where capture is just observed, nL. The upper value nH is set

by the ability of majority residents to exit the elite province for a majority run province.12 In the analysis that

follows we assume that some capture is always possible before local protests occur, so that 0 < nL < nH #

1. We assume that nL and nH are common knowledge but not contractible; in particular, the outcome n =

0 is not legally enforceable.13 Capture is not a problem in majority controlled provinces.

We can now detail the incidence of public budgets for majority and elite residents in unitary and

federal democracies. This final allocation defines the payoffs of the annual policy game, shown in Table 1.

Under democratic federalism, F, there are two cases to consider, one in which the elite leadership of the elite-

14 Majority residents living in the elite province will only leave that province if n chosen by the elite provincial

leadership exceeds the upper bound, nH, in which case all of Me residents exit. Since this will mean no grants to the elite

province and thus no capture, the elite leadership will keep n # nH and the majority population stays at M e. Thus we

assume : = (M e/M) is given in the policy stage, having been set at the constitutional stage by the drawing of provincial

lines.

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run province captures only the lower value nL of the basic grant, and a second case where the elite leadership

chooses to capture the upper value, nH. The welfare of a majority resident in an elite province will be:

Te(F; nL or H) = W + (1 - nL or H)[gF - se(q)] + 8@L(q),

depending on whether the elite chooses low or high capture, where [gF - se(q)] is the basic grant received by

a majority resident, and 8@L(q) is the typical majority resident’s utility from the uniform provision of the

public service input bundle q. The input bundle q provides a public service L(q) valued by the majority at

rate 8 > 0. Constitutional assignment of services to the provinces is equivalent to selecting a value of 8 for

the stage-two policy game; important services (education) have a high 8, less important services (street

lighting) a low 8. Since LN(q) > and LO(q) < 0, majority preferences are single-peaked in q. Welfare for

majority residents in a majority-controlled province is specified similarly, except there is no risk of capture:

Tm(F) = W + [gF - sm(q)] + 8@L(q).

The average majority resident’s welfare is a weighted average of the welfare of majority residents

residing in elite province(s) and the welfare of majority residents residing in majority province(s), where the

weights are the share of all majority residents residing in the elite province, : = (Me/M), and the majority

province(s), (1 - :) = [1 - (Me/M)]:

T(F; nL or H) = :Te(F; nL or H) + (1 - :)Tm(F).

The shares are exogenous to the policy game, set by provincial boundaries and decided at the first

constitutional stage.14 Majority resident welfare under democratic federalism is therefore:

T(F; nL or H) = W + gF[1 - nL or H:] - sF(q) + nL or H:Ase(q) + 8@L(q), (1L, 1H)

15 sF(q) = :Ase(q) + (1 - :)Asm(q). This specification of costs implicitly assumes the number of trained majority

public employees is sufficient to provide services to the all majority residents not in the elite province: m $ 1 - :. An

extension to allow for the use of untrained majority employees in federalism would be straightforward, but we do not

pursue it here. Important later is the additional plausible assumption that sU(q) > sF(q) for all q, and from the linear nature

of our technology, that sUN(q) > sFN(q) as well. Sufficient for this to hold is that [(1 - m)/:] > [au/ae]. Together then, 1

$ [(1 - m)/:] > [au/ae] constrains the relationship of majority labor supply to relative labor productivity. We assume the

constraints are met.

14

where sF(q) is the national average cost of service input provision under federalism.15 The majority prefers

low capture.

Under administrative federalism, A, the central government’s poor majority selects an equilibrium

tax rate of JU and a redistributive grant equal to gU, just as they would under a unitary system. However,

because q and b are still administered by the provinces, elite capture is possible. The weighted average

welfare for the typical majority resident under administrative federalism becomes:

T(A; n L or H) = W + gU[1 - nL or H:] - sF(q) + nL or H:Ase(q) + 8@L(q), (2L, 2H)

Here too, the majority prefers low capture.

Under unitary democracy, U, simple majority rule will ensure the national redistributive tax rate will

be set at its maximal rate (JU). In unitary democracy there are no provinces, no elite capture, and no elite

providers of mandated services; q is provided by the central government only. The average majority

resident’s welfare is therefore given by:

T(U) = W + [gU - sU(q)] + 8@L(q), (3)

where W is the majority resident’s market wage, [gU - sU(q)] is the basic grant received by the majority

resident, and 8@L(q) is the typical majority resident’s utility from valued services.

Under democratic federalism, the elite residents are assumed to reside only in elite-run provinces.

They pay redistributive taxes to the central government and receive from their elite-run provincial

governments any captured intergovernmental transfers not allocated to constitutionally mandated or centrally

chosen service inputs q. Elite residents do not receive services from funded inputs, q. Their public services

are funded separately from elite incomes available after paying redistributive taxation. The elite resident’s

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welfare depends on the central government’s choice of J, the mandated or centrally chosen level of q, and

the elite’s choice of n.

Under democratic federalism, JF < JU, and:

y(F; nL) = Y - JF + nLA[gF - se(q)]@[Me/N(JF)], (4L)

for low capture, and:

y(F; nH) = [Y - D] - JF + nHA[gF - se(q)]@[Me/N(JF)], (4H)

for high capture, when majority residents of the elite province imposes protest costs D. Under administrative

federalism, J = JU, and:

y(A; nL) = Y - JU + nLA[gU - se(q)]@[Me/N(JU)], and, (5L)

y(A; nH) = [Y - D] - JU + nHA[gU - se(q)]@[Me/N(JU)], (5H)

for the elite resident’s incomes under low and high capture, respectively. Finally, under unitary democracy

without provinces (and thus no capture) the elite resident’s welfare is simply his or her after-tax income,

y(U) = Y - JU. (6)

Clearly, for any rate of capture, elite residents prefer democratic federalism to administrative

federalism and administrative federalism to unitary governance: y(F; nL) > y(A; nL) > y(U) and y(F; nH) >

y(A; nH) > y(U). Whether the elite prefers low or high capture will depend upon the net gain per elite

resident of moving from low to high capture compared to the “protest penalty” D imposed when the high

capture strategy is adopted.

Table 1 summarizes the pay-offs in any single year of the fiscal policy game for typical majority and

elite residents, given the strategies of the majority-run central government and the elite-run provincial

governments. Fiscal strategies in any given year are assumed to be chosen simultaneously. The central

government can use provinces and set J = JF < JU (Strategy, F), use provinces but set J = JU (Strategy, A),

or ignore provinces, create a unitary democracy, and set J = JU (Strategy, U). The elite run provinces can

16 In principle the elite has a third strategy: set q = 0 and capture all of g. W e rule out this strategy by our

assumption of full information. As soon as the elite ceases to provide q, the majority knows and the majority ceases to

pay g. Thus stealing all of g by setting q = 0 is not possible.

17 For common values of Z, M , q, and :, JU > JF implies gU > gF, and therefore T(A; nL) > T(F; nL) and T(A;

nH) > T(F; nH). If nL or nH are large enough, then T(U) > T(A; nL) > T(F; nL) and T(U) > T(A; nH) > T(F; nH) as well.

16

adopt either a low (Strategy, nL) or high (Strategy, nH) rate of capture.16 Cells (1) and (4) define pay-offs

under democratic federalism, cells (2) and (5) under administrative federalism, and cells (3) and (6) under

unitary governance.

[INSERT TABLE 1]

C. Feasible Democratic Federalism: For democratic federalism to be a feasible candidate

constitution, it must provide Pareto superior allocations to those available under either administrative

federalism or unitary democracy. This is indeed the case in our specification of the fiscal policy game, since

democratic federalism(Cell (1)) ensures greater potential private goods consumption for both majority and

elite residents than is possible under either administrative federalism (Cells (2) or (5)) or under unitary

democracy (Cells (3) and (6)). Because JF < JU, democratic federalism has more elite residents contributing

to national income and lower per (elite) person fixed costs both in providing valued public services to

majority residents and in meeting fixed special interest payments. In addition, there are no potentially wasted

protest costs (as with administrative federalism) nor is there a need to use untrained providers to supply (as

with unitary democracy). (See the Appendix, Section 1.)

Whether the economic benefits of democratic federalism will be realized depends on the

constitutional ground rules that dictate the play of the annual policy game. Were the fiscal policy game to

be played only once, or with a sufficiently high discount rate so that future payoffs became unimportant,

democratic federalism would be a dominated strategy for the majority, always less preferred than either

administrative federalism or unitary governance.17 Fortunately, the policy game is played repeatedly. Under

appropriately designed constitutional rules, unending repeat play will allow the elite to punish the majority

17

whenever the majority defects from democratic federalism. For the policy game in Table 1, the elite’s

punishment strategy will be to increase capture from nL to nH.

To effectively deter majority defection from democratic federalism, however, the elite’s threat to

adopt the high capture strategy must be credible. For high capture to be a credible threat, (i) provinces must

remain as viable fiscal jurisdictions, even when the majority defects from democratic federalism; (ii) the elite

must be a political majority in at least one province; and (iii) the elite majority must prefer nH to nL when

the majority defects. Formally:

DEFINITION: CREDIBLE PUNISHMENT. The high capture strategy will be a credible punishmentstrategy when:

(i) The poor majority prefers provinces and administrative federalism as their defectionalternative, i.e., T(A; nL) > T(U) ;

(ii) The elite is a political majority in at least one province, i.e., N(JU) $ Me ; and,

(iii) The elite prefers the high capture strategy to low capture when the poor majoritydefects to administrative federalism, i.e., y(A; nH) > y(A; nL) .

The three requirements for a credible elite punishment will be met when the fiscal constitution creates an

elite province of sufficient majority population for the high capture strategy to be an effective threat and the

level of assigned services are such that provinces are valued by the majority as service providers. We call

the population constraint the constitutional Border Constraint and the choice of assigned services and, when

enforceable, the chosen input levels the constitutional Assignment Constraint. When both the border and

assignment constraints are met, the elite has a credible punishment for excessive majority taxation and

democratic federalism is a feasible constitution. Proposition 1 then shows that for at least one set of Nash

strategies – the grim trigger strategies – democratic federalism is not only feasible but also sustainable.

We specify the border and assignment constraints for credible elite punishments for two alternative

political economy regimes. The first, called the q-Regime, assumes the constitution’s border and assignment

constraints are specified for an constitutionally chosen and exogenously enforced level of q that holds under

18 See for example, Ackerman (1991; Chapter 1) who argues one role for a country’s Supreme Court is to

remind citizens of this consensus belief and to clarify its application to policy conflicts.

19 In Section IV we present evidence that South Africa may have evolved from a q-Regime (1996-2000) in

which President Mandela “enforced” the level of q negotiated in the original, bilateral, NP-ANC constitutional bargain

to a q*-Regime (2001-2006) where today, under President Mbeki, the ANC majority sets the input level to provide

constitutionally assigned services.

18

each of the three forms of democracy. In the q-Regime, the constitution (i) sets provincial borders (:), (ii)

assigns the services to be provided in the province (8), and (iii) mandates and enforces an input level (q) to

provide those services. Successful enforcement of the input bundle is assumed for the q-Regime, perhaps

emerging from a consensus belief in the ethical validity of the constitutionally assigned service standard.18

The second regime, called the q*-Regime, is arguably the more realistic environment and here we

allow the level of the input bundle q for assigned services to be endogenously chosen by the majority-run

central government depending upon the fiscal incentives implicit in each form of democracy. In the q*-

Regime, the constitution (i) selects the provincial borders (:) and (ii) assigns services (8), but the

constitutional mandate setting q is dropped. The majority-run central government now decides the level of

service inputs as q*.19 We show below that a credible elite punishment, and thus a federal democracy, may

be more difficult to sustain in the endogenous q* environment.

1. Border and Assignment Constraints in the q-Regime: For elite punishment to be credible, the elite-

run province must willingly adopt the high capture strategy when the majority defects from F to A. This will

be case when the net fiscal gain to an elite resident exceeds the costs the resident bears from provincial unrest

when they adopt high capture. Given borders (:) and assignment (8), and an exogenously enforced common

value of q, high capture is preferred when:

y(A; nH) > y(A; nL) ] (nH - nL)[gU - se(q)][Me/N(JU)] > D,

or when:

(Me/M) = : > {D[N(JU)/M]}/{(nH - nL)[gU - se(q)]} /:min(q), (7)

20 We require strict inequality because the elite are assumed to prefer to cooperate rather than defect, all else

equal.

21 Federal constitutions specify : by a map of provincial borders at the time of the adoption of the constitution;

for South Africa, see M uthien and Khosa (1998).

19

where : is the fraction of the nation’s majority residents who reside in the elite province.20 If nH is to be

credible, there must be enough majority residents in the elite province so that the additional resources

captured using nH exceed the costs imposed by local political protests when capture is high. The more

majority residents “assigned” to the elite province the greater the revenues per elite resident from high

capture. In effect, the majority residents assigned to the elite province act as “hostages” in the annual fiscal

policy game.

But : cannot be too large. For the high capture threat to be credible, the elite must still be a political

majority in their province. Thus N(JU) $Me, or:

N(JU)/M = :max $ : = (Me/M). (8)

For high capture to be a credible punishment strategy with an exogenous common q, the

constitutionally mandated population size of the elite province must satisfy the q-Border Constraint specified

as:

:max $ : > :min(q). (9q)

The border constraint defines the population size of the elite province as N(J) + Me.21

The elite can only punish through high capture if they control a political jurisdiction with budgetary

responsibilities for redistributive services and basic grants. If the central government defects from

democratic federalism, it must defect to the alternative where provinces still have fiscal responsibilities –

that is, administrative federalism must be preferred to unitary governance. This will be the case when T(A;

nL) > T(U), or equivalently, when:

sU(q) - [sF(q) - nLA:Ase(q)] > nLA:AgU, (10)

22 We assume sU(q) > sF(q); see fn. 15. A strict inequality is required since we assume, all else equal, the

majority prefers unitary democracy. From the definitions of sU(q), sF(q), and se(q): â(:) = :A[(1/am) - (1/ae)] + (1 -

m)@[(1/au) - (1/am)] + (:AnL/ae) > 0.

23 Using eqs. (7) and (8) above, qmax = [gU@(nH - nL) - D]/[(nH - nL)]@(S/ae)]. All elements defining qmax are

exogenous in the second-stage policy game. For all q # qmax, :max $ :min as required for the border constraint. See Figure

1.

20

where the LHS of the inequality represents the additional expenditures needed to provide q under unitary

governance and the RHS represents the savings in less capture by adopting unitary governance. When elite

capture (nL) is low and/or when the relative cost advantage of administrative federalism is high (ae8, au9,

m9), then administrative federalism will be preferred to unitary governance. Given the rate of capture and

the relative costs of providing q, this inequality holds when the constitutionally mandated level of q is large

enough, defined by:22

q > qmin(:) = (nLA:AgU)/[S@â(:)]. (11)

Raising q reduces the basic grant available for capture and therefore makes administrative federalism

relatively more attractive. Setting q > qmin ensures administrative federalism is the majority’s preferred

defection strategy.

But the exogenously enforced, uniform q cannot be too large. As q increases, the net returns to

capture may fall below the amount needed for the elite to find the high capture punishment strategy a

preferred response to a majority defection from F to A. The maximum common q that protects nH as a

credible punishment strategy will be that q (= qmax) for which the two border constraints just hold – that is,

where :max = :min(qmax).23 Together these lower and upper bounds define the constitutional q-Assignment

Constraint for redistributive services as:

qmax $ q > qmin(:). (12q)

When the political regime allows the exogenous enforcement of a common value of q for all forms

of democracy, then if both the q-Border and q-Assignment Constraints are met the elite will be in a position,

under democratic federalism, to credibly punish the majority for any deviations from JF to JU. The result is

21

summarized in Lemma 1.

LEMMA 1: CREDIBLE PUNISHMENTS IN THE EXOGENOUS q-REGIME. For political economiessatisfying the q-Border and q-Assignment Constraints, the high capture strategy will be a crediblepunishment strategy whenever the majority adopts a revenue-maximizing (centralizing) redistributive taxrate. (Proof: See Appendix.)

Together the q-Border and q-Assignment Constraints define a set of possible constitutional values of : and

q where the elite can credibly threaten to punish the majority when they deviate from a federal tax rate of

JF < JU; see Figure 1. (Figure 1 is calibrated to the South African political economy; see Section IV.) The

q-Border Constraint requires values of : that lie above the :min(q) curve and below the :max line. The q-

Assignment Constraint requires values of the common q that lie to the right of the qmin(:) curve and at or to

the left of qmax. The shaded area shows all values of : and an exogenously enforced q where the two

constraints are jointly satisfied. Finally, in the q-Regime, the Border and Assignment constraints hold for

any basket of assigned services – that is, for all values of 8, whether for a low 8 (street lighting) or for a high

8 (education or health care). This will not be the case in the q*-Regime, however. When q cannot be

enforced, the constitution’s choice of assigned services (8) becomes crucial.

[INSERT FIGURE 1 HERE]

There is no guarantee that both constraints can be met. First, if the lower bound for the border

constraint – :min(q) – rises, then the lowest feasible value for : – denoted :min(qmin) in Figure 1 – may rise

above :max, and the shaded area in Figure 1 may disappear. A credible elite punishment is no longer possible,

and democratic federalism is not sustainable. The number of majority “hostages” needed to make high

capture credible is greater than the number of elite residents. If so, elite political control of the province is

lost. More hostages will be needed as the penalty for high capture increases (D8) or as high capture returns

relatively less revenues either because nH falls, or nL increases, or because gU is relatively low. Maximal

grants, gU, will be low when either the initial pre-democracy ratio of elite to majority residents is small or

24 For the linear exit relationship N(J) = N0 - $@J, gU = [JU@(.5N0) - Z]/M, where JU = .5N0/$. Low values of

the initial elite to majority population – N0/M – and high values of the exit parameter – $ – both lower gU.

25 We ignore the possibility that provincial boundaries (:) may be endogenous. For any value of q, the

specification of T(F) implies the majority will prefer either a value of : = :max or a value of :min(q) to the constitutional

choice of :, depending upon whether the constant cost savings from moving a few more poor residents into the elite

province exceeds (is less than or equal to) the average income lost from such a relocation: :max is preferred if [sm(q*) -

se(q*) > nLA[gF - se(q*)] and :min(q*) preferred otherwise. In the case of South Africa :max is preferred. The

constitutionally chosen value of : = .184 is very close.

22

when the elite population has a high propensity to exit as tax rates rise.24 As Albert Hirschman (1970) first

noted: Democracy often requires loyalty.

Second, though the constitution requires a level of q services to be provided by federal or unitary

governments, there is no assurance that the majority controlled central government will comply with the

constitutional mandate. It is possible that the majority’s preferred level of q – denoted as q* – might fall

outside the feasible set in Figure 1 that allows credible elite punishments. When q is endogenously chosen

by the majority, the border and assignment constraints supporting credible elite punishments must be re-

specified. Feasible federal constitutions are still possible, but now new q*-Border and q*-Assignment

Constraints are needed.25

2. Border and Assignment Constraints in the q*-Regime: As for the q-Regime, the majority must

continue to prefer A to U when it defects and if it does defect to A, the elite-run province must willingly adopt

the high capture strategy. To ensure these conditions will be met, we define new border and assignment

constraints, conditional on the majority’s chosen levels of q in each democratic regime. We specify the

majority’s preferred level of q by equating their marginal benefits of providing q to the marginal cost of that

provision in each of the three democratic regimes, conditional upon the elite’s choice of capture:

(F, nL): 8@LN(q) = pL(:) / sFN(q) - nLA:AseN(q) Y q* = q*(:, 8; nL) = q*L(:, 8)

(F, nH): 8@LN(q) = pH(:) / sFN(q) - nHA:AseN(q) Y q* = q*(:, 8; nH) = q*H(:, 8)

(A, nL): 8@LN(q) = pL(:) / sFN(q) - nLA:AseN(q) Y q* = q*(:, 8; nL) = q*L(:, 8)

(A, nH): 8@LN(q) = pH(:) / sFN(q) - nHA:AseN(q) Y q* = q*(:, 8; nH) = q*H(:, 8)

26 This follows directly from the definitions of pL(:) and pH(:) and the facts that ae > am and 1 > nL.

27 We are assuming that high capture is profitable so that: nHA[gU - se(q*H(:, $))] - nLA[gU - se(q*L(:, $))] > 0.

This constraint places a mild upper (absolute value) bound on the majority’s price elasticity of demand for assigned

goods, generally 2 or higher.

23

(U): 8@LN(q) = pU / sUN(q) Y q* = q*U (8)

The unit prices of q in the two federal regimes, pL(:) and pH(:), equal the marginal production costs

sFN(q) minus the income benefits to majority residents that higher values of q provide because of reduced

captured revenues. These prices fall as :, the share of majority residents benefitting from low cost elite

providers, increases.26 Thus, Mq*L/M: > 0 and Mq*H/M: > 0. Majority benefits from q rise as 8 rises. Thus

Mq*L/M8 > 0 and Mq*H/M8 > 0 as well. Finally, because the prices for q under low or high capture are similar

for the F and A constitutions, the majority funds the same level of q in these regimes, denoted as q*L(:, 8)

and q*H(:, 8), respectively. Under unitary governance, there is no capture. As sUN(q) > sFN(q) and nH > nL,

therefore pU > pL(:) > pH(:) for the relevant case of : > 0. Since we assume LO(q) < 0, therefore too, q*U

(8) < q*L(:, 8) < q*H(:, 8). The border and assignment constraints can now be specified conditional on :

and 8 and their associated q*’s.

As before, the border constraint follows from our requirement that the elite province must adopt the

high capture strategy when the majority defects from F to A. Now, however, allowance must be made for

the fact that q is chosen by the central government majority, conditional on the decision by the elite to adopt

low or high capture. High capture will be preferred when:

y(A; q*H, nH) > y(A; q*L, nL) ] {nHA[gU - se(q*H(:, 8))] - nLA[gU - se(q*L(:, 8))]}A[Me/N(JU)] > D,

or when:

(Me/M) = : > {D[N(JU)/M]}/{nHA[gU - se(q*H(:, 8))] - nLA[gU - se(q*L(:, 8))]} /:min(q*L), (13)

where : is again the fraction of the country’s majority residents who reside in the elite province and now

must exceed :min(q*L).27 The upper bound for the border constraint remains the same as in the q-Regime.

For high capture to be a credible punishment strategy with endogenous q*, the constitutionally mandated

28 If T(A; :, q*L(:, 8), nL) # T(U ; qU*(8)) for a given : and 8, then there is no qL that can satisfy the

Assignment constraint; the bounds on qL*(:, $) are no t defined.

29 If qLmax(:, 8) is the tighter constraint, then the q*-Assignment Constraint becomes qL

max (:, 8) > qL*(:, 8)

> qLmin(:, 8).

24

population size of the elite province must now satisfy the q*-Border Constraint specified as:

:max $ : > :min(q*L). (9q*)

To ensure the elite has a credible punishment when the majority adopts high taxation, the majority

must prefer to defect to administrative federalism rather than to a unitary democracy. In the q*-Regime, this

will be true for any : > 0 if and only if:

T(A; :, q*L(:, 8), nL) > T(U; qU*(8)).

Majority preferences are single-peaked in q as LN(q) > 0 and LO(q) < 0. Given single-peaked preferences in

q, the majority will prefer administrative federalism to unitary governance when there exists a best qL*(:,

8) bounded between the values qLmin(:, 8) and qL

max(:, 8), where qLmin(:, 8) and qL

max(:, 8) are the two

values of qL – one less than q*L(:, 8) and the other greater than q*L(:, 8) – that are just sufficient to equate

majority welfare under administrative federalism to the welfare threshold set by unitary governance.28 As

with exogenous q, however, there may be a tighter upper constraint on the upper value of q*L(:, 8), defined

by that qL*max(:, 8) where the border constraints just hold: :max = :min(q*L). Assuming qL*max(:, 8) defines

the relevant upper bound for q*L, then the q*-Assignment Constraint is specified as:29

qL*max(:, 8) $ q*L(:, 8) > qLmin(:, 8). (12q*)

Given provincial borders (:), meeting the q*-Assignment Constraint requires the right selection of

services for provincial assignment: Should we assign high 8 (education) or low 8 (street lighting) services

to provinces? The importance of selecting the right bundle for provincially assigned public services is seen

most easily when we note that T(A; :, q*L(:, 8), nL) > T(U; qU*(8)) as:

[L(q*L(:, 8)) - pL(:)@q*L(:, 8)] - [L(q*U) - pU@q*U] > nL@:AgU, (14)

The LHS of the inequality measures the difference between the consumer surplus earned by a typical

30 Public finance economists will recognize the shaded area in Figure 2 as the total burden of a tax,

approximated by the sum [pU - pL(:)]@q*U + .5@[pU - pL(:)]@[q*L(:) - q*U] = .5 @[pU - pL(:)]@[q*L(:) + q*U]. When .5 @[pU -

pL(:)]@[q*L(:) + q*U] > nL@:AgU the q*-Assignment Constraint is met, from which the intuition above follows directly.

25

majority resident under administrative federalism when the price of assigned services is pL(:) and the surplus

earned by the majority resident under unitary democracy when the price of a comparable service bundle is

pU. Since pU > pL(:), consumer surplus is larger under administrative federalism, shown as the shaded area

in Figure 2.30 (Calibrated to the South African political economy; see Section IV.) Because of elite capture,

however, administrative federalism also imposes an income loss nL@:AgU on the average majority resident.

[INSERT FIGURE 2 HERE]

To meet the q*-Assignment Constraint, assigned services – indexed by 8 – must generate a gain in consumer

surplus from adopting administrative federalism rather than unitary governance that exceeds the income loss

of elite capture. From Figure 2, the gain in consumer surplus grows when assigned services are highly valued

– so 8@LN(q) shifts outward and q*L(:) and q*U are large – and when elite provinces have a strong production

advantage over unitary governance so [pU - pL(:)] is large as well. When these conditions are met, provinces

are important to the majority and worth the “cost” of capture. South Africa’s decision to assign K-12

education, primary health care, and the administration of income transfers to provinces seems consistent with

the q*-Assignment Constraint. We can now state Lemma 2.

LEMMA 2: CREDIBLE PUNISHMENTS IN THE ENDOGENOUS q*-REGIME. For politicaleconomies satisfying the q*-Border and q*-Assignment Constraints, the high capture strategy will be acredible punishment strategy whenever the majority adopts a revenue-maximizing (centralizing)redistributive tax rate. (Proof: See Appendix.)

[INSERT FIGURE 3 HERE]

The shaded area in Figure 3 (again, calibrated for the South African political economy) shows the

set of provincial borders (:) and chosen levels of assigned services (q*L) that jointly satisfy the requirements

of Lemma 2 for credible elite punishment. The rising solid lines within the shaded area represent the

portions of the demand curves q*L(:, 8) that satisfy the q*-Border Constraint, with higher values of : raising

26

q*L along a demand curve and higher values of 8 shifting the demand curve to the right. For example, at :*

= .18, representing 18 percent of the majority population assigned to the elite province, the majority would

prefer an input bundle q*L = .53 if the assigned service utility weight 8 were equal 2840. Higher utility

weights slide the demand curve to the right, and for :* = .18, might lead demands for q*L outside the feasible

set, such as q*L = .65 when 8 = 3487. Each point within the shaded area represents one combination of

provincial borders (:) and assigned services (8) that satisfies the q*-Border and q*-Assignment Constraints.

As in the q-Regime, however, there is no guarantee that both constraints can be jointly satisfied. Here too,

the set of feasible federal constitutions shrinks as :min(q*L) rises towards :max and for the same reasons as

obtained in the q-Regime: a rising penalty for high capture (D), declining relative return (nH - nL) to high

capture, or a low value of gU because of low initial elite populations or high elite exit.

3. Comparing Regimes: Figure 3 illustrates that between the q- and q*-Regimes, losing the ability

to enforce a particular level of redistributive services may significantly constrain the set of feasible federal

constitutions. When the majority cannot credibly promise to provide a constitutionally mandated level of

q, tighter bounds on the other two dimensions of the federal constitution – borders and assignments – will

be needed to ensure the constitution can be enforced. First, in the q*-Regime, when the majority defects

from F to A, the elite’s decision to punish and adopt nH must be consistent with the majority’s decision to

adopt q*H(:, 8). For any initial value of q*L = q, it must be true that high capture generates less revenues

for the elite in the q*-Regime, since nHA[gU - se(q*H(:, 8))] < nLA[gU - se(q)] as q*H(:, 8) > q*L = q. To cover

the protest costs (D) borne by each elite resident when nH is chosen, more majority residents must be assigned

as “hostages” to the elite province. Thus for each value of q*L = q in Figure 3, : must rise in the q*-Regime.

This is shown as the :min(q*L) curve everywhere above the :min(q).

Second, to ensure the majority does defect only as far as A, and not to U, the welfare gain from

staying in A must just exceed the benefits saving what had been capture – nL@:AgU – by moving to U. In the

q-Regime, the welfare gain in A is the savings in costs from using provinces to provide the exogenous level

27

of q; see the LHS of eq. (10). These savings are represented by a rectangle, such as the heavily shaded area

in Figure 2. If nL@:AgU just equals this heavily shaded rectangle, then qmin(:) would be represented by q*U(8)

in Figure 2. In the q*-Regime, however, the majority can choose q. By selecting A over U the majority gains

not just the cost savings (the rectangle) of A, but they also gain consumer surplus by being able to buy more

q (a triangle). Because pL(:) < pU, they do. Thus q*L > qmin(:). Where the area of consumer surplus just

equals nL@:AgU defines qLmin(:, 8); thus qL

min(:, 8) > qmin(:). For any choice of :, the minimal q, or

equivalently the value of assigned services 8, must be higher in the q*-Regime. This is shown in Figure 3

as the qLmin(:, 8) curve everywhere to the right of the qmin(:).

Together, the q*-Regime’s induced upward shift of the Border Constraint and rightward shift of the

Assignment Constraint shrink the set of borders (:) and assignments (8, or equivalently, q*L) that permit

feasible federalism. We summarize this result as:

LEMMA 3: FEASIBLE FEDERALISM WITH ENDOGENOUS SERVICE LEVELS. When theconstitution loses the ability to enforce the level of assigned services (q), then for credible elite punishmentsand feasible federalism, either elite provinces specified by : must be larger or provincially assigned servicesspecified by 8 must be more highly valued, or both. (Proof: See Appendix.)

Lemma 3 provides a formal foundation for a useful intuition: Democratic federalism is likely to survive as

a viable institution only in societies first, with enough loyal elite residents, and second, with enough low-

cost elite providers of public services valued highly by the majority. At the time of its transition, South

Africa appears to have met this test.

D. Sustainable Democratic Federalism: Ensuring the feasibility of democratic federalism does not

guarantee the institution will survive as a long-run equilibrium of the annual policy game. Though both the

majority and the elite credible punishments if the other deviates from the federal agreement, democratic

federalism only survives if those punishments are sufficient to discourage defections from the strategy pair

(F , nL) in Table 1. Formally:

DEFINITION: SUSTAINABLE DEMOCRATIC FEDERALISM. Democratic federalism will be asustainable constitutional regime for the infinitely repeated policy game if the strategy pair (F, nL) is a

28

subgame-perfect Nash equilibrium.

For the majority, the strategy F requires a choice of the central government’s tax rate be a value of

JF < JU, and its grants to the provinces be gF < gU. For subgame perfection, this strategy choice (JF, gF) must

allocate the surplus available under democratic federalism to the poor majority and the current elite in such

a way that both prefer democratic federalism to either administrative federalism or unitary democracy in all

budget years. To ensure the elite are better off under democratic federalism taxes cannot be too high; the

majority’s fiscal choices must satisfy JU > JFmax

$JF or equivalently, gU > gmax $ gF, where JFmax is just

sufficient to ensure the elite will continue to play nL under democratic federalism. To ensure that the poor

majority are better off under democratic federalism, total redistributive spending cannot be too low; the

majority’s fiscal choices must satisfy gF > gmin or equivalently, JF > Jmin, where gmin is the intergovernmental

transfer just sufficient to ensure that the majority prefers democratic federalism. For subgame perfection,

therefore, the majority chosen tax rate and total intergovernmental transfers under federalism must satisfy

JU > JFmax $ JF > JF

min, or equivalently, gU > gmax $ gF > gmin. In the analysis that follows, we focus on the

bounds gU > gmax $ gF > gmin, specified separately for the q-Regime and the q*-Regime.

Proposition 1 specifies gmax and gmin for the q- and q*-Regimes for one pair of subgame perfect

strategies and then proves that there exists a majority preferred fiscal choice (JF, gF) and an elite capture

decision (nL) satisfying those bounds. The strategy choices considered here are grim trigger strategies

defined as:

DEFINITION: GRIM TRIGGER STRATEGIES. The poor majority and the elite are said to play grimtrigger strategies at each stage of the policy game if:

(i) along the equilibrium path, the majority-run central government selects (JF, gF) and theelite-run province selects nL; and,

(ii) off the equilibrium path, were the majority central government to have selected (JU, gU)the elite would play nH in all subsequent budget periods, and where, were the elite provinceto have selected nH, the majority would play either administrative federalism (A) selecting(JU, gU), or unitary democracy (U) selecting JU in all subsequent budget periods.

31 In this infinitely repeated Prisoners’ dilemma game, the players’ payoffs in the non-cooperative Nash

equilibrium of the annual stage game are also their reservation payoffs. In this special case, the grim trigger strategy is

equivalent to Abreu’s (1988) strongest credible punishment strategy; see Gibbons (1992, p. 99). Softer punishment

strategies might be considered, as the grim trigger strategy in this game, while subgame per fect, is not weakly

renegotiation proof; see Farrell and Maskin (1989). Agreeing to let “bygones be bygones,” the elite and majority can

adopt a strategy pair that allows them to move from punishment forever back to cooperation in time. If so, defection

becomes less costly making federalism harder to maintain; the range [gmax, gmin] of feasib le federal fiscal contracts gets

smaller. Thus grim trigger strategies give federalism its best chance for adoption in this game with full information.

29

These grim trigger strategies are the most extreme form of punishment one player can impose on the

other for defection in this game; if democratic federalism cannot be sustained under these strategies, it cannot

be sustainable under any other feasible strategies.31 Were the majority to defect and select JU, the elite would

punish by selecting the high capture strategy forever. Were the elite to defect and adopt a high capture

strategy, then the majority-run central government would punish by selecting JU and using administrative

federalism forever, or by selecting JU , and using unitary democracy forever. For any provincial size (:) and

assignment (q) satisfying the border and assignment constraints, the majority prefers to punish an elite

defection (nH) using unitary democracy when T(U) $ T(A; nH) in the q-Regime and T(U; qU*(8)) $ T(A;

:, q*H(:, 8), nH) in the q*-Regime, and to punish using administrative federalism when the inequalities are

reversed. We can now state our main result.

PROPOSITION 1: SUSTAINABLE DEMOCRATIC FEDERALISM: For elite provincial size andredistributive assignment satisfying the Border and Assignment Constraints, there exists a grim triggerstrategy equilibrium where democratic federalism is sustainable. For majority and elite residents withdiscount factor 0 < * # 1, that equilibrium is characterized by:

(1) For majority punishment strategy U, the majority chooses gF within the bounds:

gU > g*max(U) > gmax(U) $ gF > g*min(U) > gmin(U);

(2) For majority punishment strategy A, the majority chooses gF within the bounds:

gU > g*max(A) > gmax(A) $ gF > g*min(A) > gmin(A); and,

(3) The elite province adopts nL. (Proof: See Appendix. )

A complete specification for each value of gmax and gmin for the q- and q*-Regimes is given in the Appendix.

Whether U or A is the majority’s preferred punishment, sustainable grants are unambiguously higher

30

in the q*-Regime than the q-Regime. Intuitively, when the q- and q*-Regimes have identical allocations in

democratic federalism, given the majority the right to set q at preferred levels when they do defect makes

defection more attractive for the majority and less so for the elite. This raises the minimal transfers needed

to hold the majority in democratic federalism and allows a higher tax rate on the elite before they will be

tempted to defect. Both effects favor the majority and hurt the elite by moving the range of constitutionally

acceptable intergovernmental transfers towards more redistribution. Not only does the q*-Regime make

democratic federalism more difficult to achieve in the annual policy game (Lemma 3), it also makes it

potentially more costly for the elite to accept at the constitutional stage (Proposition 1).

It is also important to understand the role of impatience for constitutional agreement, measured here

by the discount factor *, which may differ for the two groups. Lower values of * represent greater

impatience. The full specification of Proposition 1 in the Appendix show that a more impatient elite implies

lower values for g*max(U), gmax(U), g*max(A), and gmax(A), while a more impatient majority will imply larger

values for g*min(U), gmin(U), g*min(A) and gmin(A); see the Appendix. Importantly, if both parties are very

impatient, we cannot rule out the possibility that gmin(C) > gmax(C) in all cases and that there will be no

equilibrium transfer that is capable of sustaining democratic federalism and also agreeable to both parties

at the constitutional stage. Successful democratic constitution writing requires at least some commitment

to the long-run by the residents of the new democracy.

Finally, while any value of gF satisfying Proposition 1 will be consistent with a sustainable federal

democracy, a choice must be made. Constitutional negotiators might choose to divide the surplus earned in

democratic federalism equitably between the majority and the elite by setting gF midway between gmin and

gmax. But such a choice must be enforced exogenously. The central government’s majority clearly prefers

JF = Jmax and gF = gmax. It is therefore useful therefore to explore the likely determinants of gmax.

In the q-Regime either gmax(U) or gmax(A) will result or in the q*-Regime either g*max(U) or g*max(A)

is the outcome. Which value of gmax sets the upper bound on transfers will depend upon whether unitary

31

democracy or administrative federalism is the majority’s preferred punishment strategy for elite deviations

to high capture. Comparing T(U) to T(A; nH) in the q-Regime and T(U; qU*(8)) to T(A; :, q*H(:, 8), nH)

in the q*-Regime shows that unitary democracy will be the preferred punishment when high capture is costly

(nH8) or when the cost disadvantage of leaving provincial for unitary government provision of redistributive

services is small. This cost disadvantage will be small when the majority has a relatively well-trained cadre

of majority loyal public providers (ae9, am8) sufficient to meet most all of the majority’s service needs (m8).

Corollary 1 provides a useful comparative static result:

COROLLARY 1: gmax(U) > gmax(A) and g*max(U) > g*max(A). For federal constitutions satisfying requiredBorder and Assignment Constraints, there exists Grim Trigger Strategy Equilibria for majority punishmentstrategies of either unitary democracy or administrative federalism forever, where (i) democratic federalismis sustainable, and (ii) gmax(U) > gmax(A) in the q-Regime and g*max(U) > g*max(A) in the q*-Regime. (Proof:See the Appendix)

When the majority has a large and well-trained pool of public employees it will be able to negotiate,

or set in annual budgets, a relatively high level of redistributive grants. This bargaining advantage has the

downside, however, of discouraging the elite from accepting democratic federalism at the time of the

transition. Democratic federalism is most likely an jointly acceptable, and therefore sustainable, constitution

when both parties to the negotiations are needed for democracy’s long-run success. When the majority

offers peace and the elite provides efficiency in the production of valued public services, then democratic

federalism, and perhaps democracy itself, has a chance. Sections IV and V present evidence for South Africa

as a case on point.

IV. Is South Africa’s Federal Democracy Sustainable?

There is little doubt that South Africa’s transition from autocracy to democracy would not have

occurred were the majority ANC and the minority NP and IFP negotiators not willing to accept an interim

federal constitution with at least one politically protected province for each minority party, and with each

province promised significant, but not fully autonomous, fiscal powers. It was only after this agreement was

32 Waldmeir (1997, Chapter 13).

33 The interim constitution required the FFC to be composed of one representative appointed by the executive

committees of each of the nine provinces and nine at-large representatives appointed by Nelson Mandela. No members

of the FFC were to ho ld party office nor be candidates for public office and all were to be recognized experts in either

economics, accounting, public administration, or taxation. President Mandela used his appointments to ensure a

numerical balance between ANC and NP representation on the commission. Similarly balanced commissions were

established to draft the other major sections of the final constitution, those on human rights, legislative and presidential

powers, courts and administration justice, and public administration.

32

reached on April 19, 1994 that democratic elections went forward.32

The resulting 1994 Interim Constitution left many details unspecified, however. To set the

constitutional rules for fiscal policy, the interim constitution created the Financial and Fiscal Commission

(FFC) with equal representation from the ANC and old ruling National Party.33 With equal representation

on the commission, both parties to the new democracy could block constitutional recommendations by the

FFC. In fact, all FFC recommendations were unanimously supported by the commission members. The FFC

recommended a fiscal assignment that allocated all important taxing powers to the central government and

the three important redistributive services – K-12 education, primary health care, and social security

(welfare) grants – to the provinces. Without significant taxing powers, the provinces required centrally

funded intergovernmental transfers. The FFC recommended that the aggregate level of grants be set centrally

by the Ministry of Finance in consultation with the FFC and that the allocation of total grants across

provinces be set by an FFC- specified funding formula that ensured adequate financing for provincially

provided redistributive services and a “significant” basic grant for general administration and other provincial

services. The FFC’s recommendations were unanimously approved as part of the final 1996 Constitution.

Table 2 summarizes the resulting system of federal finance. The table reports the total central

government tax revenues per capita, total redistributive grants per capita, the allocation of total grants to the

elite (Western Cape) and majority (Other) provinces, provincial grants per capita needed to fund assigned

services in the elite and majority provinces, and provincial basic grants per capita to fund other provincial

34 See FFC, The Allocation of Financial Resources Between the National and Provincia l Governments, FY

1996/97, September 8, 1995, p. 11, and FFC, The Allocation of Financial Resources Between the National and

Provincia l Governments, FY 1997/98, No Date, p. 23.

35 Waldmeir (1997, p . 228).

33

services in the elite and majority provinces.34

[INSERT TABLE 2 HERE]

Four conclusions are evident from Table 2. First, provincial governments have been given a significant and

growing role in the provision of the important redistributive services in South Africa, funded entirely by

grants from the central government. Second, the Western Cape receives approximately 20 percent less in

assigned services grants as required by the relative differences in public employee productivity. Third, while

most (�75 percent) of the allocated grant monies are targeted towards meeting assigned redistributive

services, basic service grants are significant and do allow for capture. Fourth, the initially high level of basic

grants given to the Western Cape have been gradually reduced to levels more consistent with majority

provinces, particularly beginning in FY 2003/04. In the early years of the democracy, there was a conscious

decision by the FFC to ease the transition into the new democracy for the elite province. It was feared that

large initial cuts in discretionary spending in the Western Cape would lead to sudden lay-offs of white public

employees, an important political ally of the National Party at the time of democratic negotiations.35

While funding patterns are consistent with the description of the democratic federalism, the evidence

in Table 2 only begins the analysis of our fundamental question: Is the South African federal constitution

sustainable? To answer this question we evaluate whether the requirements of Lemmas 1 and 2 and

Proposition 1 are met by the South African political economy. We do so in five steps. First, we specify the

model’s required economic and demographic parameters for the South African economy at the time of the

transition; see Table 3. Second, we translate the new constitution’s border and assignment rules into

estimates for the border and assignment constraints. Third, we confirm that the constitution’s initial

constraints, denoted as : and qFFC, meet Lemma 1's conditions for a credible elite punishment strategy.

36 A Data Appendix available upon request provides the details for this calibration.

34

Fourth, using Proposition 1 and our calibration of the South African political economy, we compute the range

of aggregate grants consistent with sustainable democratic federalism. We assume gF equal to the maximal

redistributive grant consistent with democratic federalism. Given qFFC we then compute the constitution’s

required service grants for elite and majority provinces, and then finally, the level of basic grants for elite

and majority provinces. Predicted grants are reported in Table 4. While total predicted and actual

intergovernmental grants are quite close – and consistent with sustainable democratic federalism – predicted

grants needed to fund qFFC are well below actual service grants for all fiscal years FY 2001 and beyond. The

results are suggestive of a shift in the enforcement of assigned services, from a q- to a q*-Regime. It is

suggestive that the FY 2001 budget was the first decided by a post-Mandela ANC central government. Fifth,

we therefore estimate the ANC’s revealed preference for redistributive public goods under the assumption

that South Africa is now in a q*-Regime and compute q*L = qANC. We then examine whether : and qANC

satisfy the q*-Border and q*-Assignment Constraints of Lemma 2. They do, barely. Against the

requirements of Lemmas 1 and 2 and Proposition 1, we conclude that South Africa’s new federal constitution

is currently sustainable.

A. Calibration: Table 3 summarizes our best estimates of our model’s required economic and

demographic parameters for South Africa at the time of its political transition.36 Using South African Census

data for 1991 and 2001, we estimate the initial (pre-tax) elite and majority adult (voting) age populations as

N0 = 9.6 million and M = 25 million residents and elite and majority pre-tax incomes as Y = 86,000 (real

2000) Rand/Elite Adult (�$22,000 USD in 1996) and W = 9,700 (real 2000) Rand/Majority Adult (� $2,500

USD), respectively. No South African data are available to estimate $, the elite’s response to redistributive

taxation. Given this uncertainty we adopt a conservative estimate for $ = .00015, one making federalism

37 The calibration for $ was chosen to imply a plausible peak to the revenue hill from the taxation of elite

residents. Setting $ = .00015 implies a revenue-maximizing redistributive tax rate per elite resident of 32,000 Rand,

or approximately 37 percent as the maximal share of pre-tax elite income that can be allocated to fiscal redistribution.

We estimate the required tax rate on individual personal incomes needed to fund central government expenditures other

than redistributive aid as approximately 30 percent; Financial and Fiscal Commission (1998), Tables 2.1 and 2.6 and

Development Bank of South Africa (1995), Table 60. Assuming taxation for redistributive aid becomes an added

burden for the elite, the choice of $ implies a revenue maximizing tax rate for the entire central government budget of

approximately 67 percent (� .67 = .37 + .30). As a possible point of comparison, Gruber and Saez (2002, p . 26) estimate

the revenue maximizing tax rate on taxable personal income for U.S. households at 71 percent.

38 See Reinikka and Svensson (2003, 2004).

39 Fiske and Ladd (2004), Tables 6.6 and 6.7.

40 Fiske and Ladd (2004), Table 6.7 for teachers, and the Development Bank of South Africa (1995), Table 26

for health care professionals. For details of this estimate, see our Data Appendix, available upon request.

41 Fiske and Ladd (2004), Tables 6.5 and 6.6.

35

more difficult to sustain.37

[INSERT TABLE 3 HERE]

Estimates of the elite’s potential rate of capture of unallocated grants are from recent estimates of

the rates of capture by elite bureaucrats running Ugandan local schools: nL = .20 and nH = .85.38 The

protest costs borne by elite residents from engaging in high capture was set at .02 of elite resident income

or D = 1720 (real 2000) Rand/Elite Resident; .02 is our estimate of the cost as a percent of income imposed

on elite residents’ by Black unions’ political protests during the latter stages of apartheid.

We specify public employee productivity to be proportional to years of training and use as our

estimates of ae, am, and au the years of schooling of white (elite) teachers (= 17 years), certified Black and

Colored teachers (am = 14 years), and uncertified Black teachers (au = 10 years), respectively.39 The fraction

of the majority population that can be serviced by trained majority public employees (m) was computed

knowing the eligible majority population and the number of trained majority teachers and primary care

medical providers: m = .85.40

We adopt as the estimate of the common public employee salary S the average salary for teachers

in the Western and Eastern Capes in 2001.41 Given the estimates of ae, am, au, S, and m, the costs per majority

42 Source: www.reservebank.co.za; Series K PB2003J.

43 See M uthien and Khosa (1998).

44 In the 2004 Western Cape elections, the ANC won 45 percent of the vote, while a four-party coalition of elite

parties won 51 percent of the vote; see www.elections.org.za. We therefore define : = (M e/M) so that N(JF)/[Me + N(JF)]

= .51. N(JF) is estimated to be only slightly larger than 4.8 Million since the equilibrium value of JF is shown to be very

36

resident of providing any level of redistributive services using alternative providers are given in Table 3.

To ensure the cooperation of the Zulu Chief Buthelezi and his Inkatha Freedom Party at the time of

the interim constitution, special payments were implicitly promised to the new KwaZulu-Natal province.

We assume the amount paid equaled the payments to the original KwaZulu homeland under the old apartheid

regime: Z = 600 Million (Real 2000) Rand.

The discount factor * is specified to equal (1/1+r) where r is the rate of time preference for elite and

majority residents equal to the real rate of return on ten year South African bonds, averaged over the period

1996-2006; r = .03.42 Thus * = .97.

Finally, we compute the revenue maximizing redistributive tax as JU = N0/2$ = 32,000 (real 2000)

Rand/Elite Adult, the implied tax-paying elite population N(JU) = 4.8 million elite adults, and the maximal

grant per majority adult gU = [JUAN(JU) - Z]/M = 6,120 (real 2000) Rand/Majority Adult. The maximal

redistributive tax and grant are expected to be chosen by the majority under unitary democracy.

B. The Constitution’s Original Border and Assignment Constraints: The 1996 Constitution

created two provinces meant to accommodate the old ruling elite, the urbanized Western Cape centered

around Cape Town and the rural Northern Cape.43 Only the Western Cape has remained in elite political

control. While the constitutional allocation of the voting age population was sufficient to ensure elite control

of the Northern Cape, white voter turnout has always been too low to give an elite victory. Thus we consider

the Northern Cape a majority province. A value of : = .184 allocating no more than 18.4 percent of the

majority population into the Western Cape is sufficient to ensure continued political control of this province

by the elite.44

close to JU; see Table 4. Thus M e = 4.6 Million, and : = (M e/M) = 4.6M/25M = .184.

45 The value of (X/M) is estimated from FFC targets and the assumption that (1) each majority adult has one

child requiring .026 education professionals per majority resident; (2) each medical professional can provide 3.5 visits

to each of 500 majority residents a year requiring .002 health care professionals per majority resident; and (3) that

approximately 17 percent of the majority population qualifies for some form of income assistance for an average

spending per majority resident of 765 Rand per year or, in fiscally equivalent units of a public employee, about .0095

public employees per majority resident. Together the mandates require funding sufficient to pay for .0375 public

employees per majority resident.

46 We can offer only anecdotal evidence on President Mandela’s role here. The authors served as advisors to

the FFC from 1994-1999 and to the Finance Ministry from 1996-1999. It is our impression that during this period the

Finance Ministry accep ted the FFC recommendations and forwarded those funding requests, largely unaltered, to

Parliament. The ANC dominated Parliament then approved the M inistry’s budgets with no changes.

37

The 1996 Constitution empowered the FFC to set the constitution’s standards for redistributive

services. The FFC’s minimum requirements were at least 1 teacher per 38 school-aged children, 3.5

preventive health care clinic visits a year for each majority adult and child for health care, and 4500 (real

2000) Rand for each eligible (elderly, disabled, child in poverty) majority resident for social security

transfers. Together, these targets require redistributive grants sufficient to fund the equivalent of .038 public

employees per majority resident.45 Given q = aA(X/M), and assuming an average value of a = 14 (years), we

estimate the FFC’s minimum mandated service level to be qFFC = 14A(.038) = .53.

C. Is the Elite Punishment Strategy Credible? Figure 1 shows the set of all border and assignment

requirements of Lemma 1 required to ensure the elite’s punishment strategy of high capture (nH) is credible

under the assumption that South Africa is in a q-Regime. The original constitutional standard of qFFC were

set by the FFC, a constitutional commission with equal ANC majority and NP elite representation. The FY

1996-2000 budgets submitted by the Finance Ministry under the (presumed) directive of President Mandela

respected the FFC recommendations, holding to the qFFC constraint; see Table 2.46

The fully shaded area in Figure 1 shows all constitutionally chosen values of : and q that will satisfy

Lemma 1's border and assignment constraints for South Africa’s calibrated political economy. The vertical

: axis of Figure 1 defines the border requirements for the new constitution. The upper bound for : is the

maximal share of the majority population that can be allocated to the province to ensure that the elite is

47 See fn. 24 above.

48 Unitary governance is the preferred punishment when T(U) $ T(A; nH). For our calibration of the South

African economy, T(U) = :@nH @[gU - se(qFFC)] = (.18)(.85)@[6120 - 2494] = 555 > 276 = [3210 - 2934] = [sU(qFFC) -

sF(qFFC)] = T(A; nH).

38

always in political control: :max = N(JU)/M = 4.8m./25m. = .192. The lower bound for : shown as the line

:min(q) defines the share of majority population that must be allocated to the elite province to ensure enough

“hostages” so that the elite’s choice of nH is a credible punishment. The horizontal axis q represents the

required level of public inputs to meet constitutional assignment, measured as the number of public employee

training years per majority resident. The upper bound for redistributive assignment is specified as qmax =

.74.47 The lower bound for assignment is specified the line qmin(:). Assuming a Mandela enforced q-Regime,

Figure 1 shows the original specification of the South African constitution as : = .184 and qFFC = .53 met the

border and assignment requirements of Lemma 1 for credible elite punishment and therefore for feasible

democratic federalism.

D. Fiscal Policies and Sustainable Federalism: Proposition 1 states that a federal constitution

satisfying a political economy’s border and assignment constraints can be sustained when intergovernmental

transfers are bounded as gmax $ gF > gmin, where the precise specification of the bounds depends upon the

majority’s preferred punishment strategy. When calibrated to the South African political economy, we

estimate the majority’s preferred punishment when the elite defects is to move to unitary governance.48

Table 4 reports the estimated values for the bounds on aggregate redistributive transfers gmax(U) and

gmin(U) when unitary governance is the majority’s preferred punishment. Assuming the ANC majority

chooses the maximal level of redistributive spending consistent with sustainable federalism, then gF = gmax(U)

= 3365 Rand per capita. For the constitution assignment of qFFC = .53 and the cost specifications in Table

3, we estimate assigned service grants for the elite province, se(qFFC), to be 1372 Rand per capita and the

assigned service grants in the majority provinces, sm(qFFC), to be 1665 Rand per capita; see Table 4. The

provinces’ unconstrained basic grants revenues, be and bm, are the differences between total grants and

49 For each of the six Mbeki fiscal years, we can estimate a separate value for q that can be funded by the per

capita grants reported in T able 2 , adjusted upward by divid ing by the ratio of majority adults to total residents (= .55)

to be comparable to the costs of q per majority adult resident. In each fiscal year, qe = se(q)/4706@.55 and

qm=sm(q)/5714@.55, where se(q)and sm(q) are as reported in Table 2. The average value of q over the six observations

is .65 (s.e. = .07).

50The additive specification of pub lic service preferences as 8AL(q) = 8Aln(q) implies a zero income elasticity

of demand (from additive preferences) and a unitary (-1) price elasticity of demand (from ln(q)): q = 8/p, where p is the

unit cost of q. Assuming the data in Table 2 is from a democratic federal regime then p = pL(:) = sFN(q) - nLA:AseN(q).

Thus 8 = pL(:)@q = sF(q) - nLA:Ase(q) = (1-:)Asm(q) + :A(1-nL)Ase(q). For FT 2001-2006, we have six observations for

39

mandated service grants and equal 1993 Rand per capita in the elite province and 1700 Rand per capita in

the typical majority province; see Table 4.

[INSERT TABLE 4 HERE]

Two trends are evident when we compare predicted (Table 4) and actual (Table 2) intergovernmental

transfers. First, total transfers in Table 2, below those predicted in Table 4 for sustainable democratic

federalism in the Mandela years, are now very close to predicted gmax(U). Second, while the constitutional

service assignment (8) has remained unchanged since 1996 – still K-12 education, basic health care, and

administration of social service grants – predicted service grants assuming qFFC = .53 are well below Table

2's actual funding for assigned services. A trend break between predicted and actual assigned service funding

occurs between FY 2000 and FY 2001, the last budget from President Mandela and the first budget under

newly elected President Mbeki. The break is suggestive of a regime shift, from a Mandela enforced q-

Regime at qFFC = .53, to an Mbeki majority rule q*-Regime, where q is allowed to reflect ANC preferences

for the assigned services. From the cost specifications in Table 3 and Table 2's actual transfers for mandated

services to elite and majority provinces, we can estimate the ANC’s revealed preferred service level: qANC

= .65 (s.e. = .07) for the sample period FY2001-2006.49

Assuming the Mbeki presidency is a q*-Regime, we must re-evaluate the feasibility of democratic

federalism against the requirements of Lemma 2. To do so requires an estimate of 8 for the constitution’s

currently assigned provincial services. We specify 8AL(q) = 8Aln(q). For budget years FY2001-2006, we

estimate 8 = 3487 (s.e. = 416).50 Given 8 = 3487, we compute the qLmin(:, 8) and :min(q*L) schedules

se(q) and sm(q) as reported in Table 2. Given : = .184 and nL = .20 , we estimate the mean value of 8 over the sample

years as 3487 (s.e. = 416).

51 It is worth exploring how sensitive the conclusions are to the calibration choices in Table 3. Conditional on

the values of all other parameters, increasing either au from 10 to 13.5 years of training or the share m of majority

residents covered by trained public employees from .85 to .98 will so lower the cost of unitary governance that the elite

will be unable to rationally prevent the majority’s adoption of unitary governance. That is, gmin(U) > gmax(U), and there

will be no values of gF that can satisfy the minimal bargaining demands of both the majority and the elite. Both au and

m increase if the ANC expands the training of majority teachers, nurses, and doctors, but to date the ANC has continued

to rely upon white elite providers of public services; see Fiske and Ladd (2004 , Chapter 10).

Reducing the discount factor * from .97 to .89 also threatens the long-run viability of the federal compact. For

* = .89 ( r =.11), the majority demands an increase in current year redistribution which exceeds the willingness of the

elite to contribute, and again, gmin(U) > gmax(U) and no federal agreement can be sustained. The fact that South Africa

has maintained fiscal discipline at current world interest rates, suggests r < .11.

Finally, holding fixed all other parameters, increasing D above 2950 Rand, narrowing the gap between high and

low capture so that (nH - nL) < .38 , raising the exit elasticity to $ > .00025 , or lowering the initial population ratio

(N0/M) < .30 will shrink the shaded areas of feasible federalism in Figures 1 and 2 to zero. In these cases, Lemmas 1

or 2 cannot hold for any values of :, 8, and q. In such cases, elite punishment is not credible and democratic federalism

cannot be sustained. For South Africa, however, our estimated values of D, (nH - nL), $, and (N0/M) are comfortably

within the range needed for credible elite punishments.

40

which, along with :max = .192, define the set of borders (:) and assignments (8, equivalently q*L) which can

satisfy the q*-Border and q*-Assignment constraints of Lemma 2; see Figure 3. President Mbeki’s

administration has preferences for assigned provincial services which lie just outside Lemma 2's feasible set

for a credible elite punishment. But not significantly so. The upper bound for the q*-Assignment constraint

is q*Lmax = .64, within the confidence interval for our estimate of qANC = .65 (s.e. = .07). Though pushing the

limits of sustainable federalism, both with respect to the growth in gFmax and the chosen level of redistributive

services, we conclude that President Mbeki has maintained South Africa’s constitutional commitment to

democratic federalism.51

V. Governance and the Economic Value of Transition

Did South Africa’s elite make the correct economic decision when they abandoned apartheid for

democratic federalism? Under democratic federalism, the elite pays significant redistributive taxes. Under

apartheid, the elite paid lower redistributive taxes, but incurred the military costs of running a repressive

regime, and in addition, bore potentially significant economic costs from international sanctions and

domestic labor unrest. Table 5 provides estimates of the economic costs to the elite of the apartheid regime.

41

Table 6 compares the elite’s potential improvement in lifetime economic welfare under unitary and federal

democracies over their economic prospects from maintaining apartheid. As an economic matter alone, we

find the elite made the correct decision in opting for democratic federalism, and indeed, they would have

preferred unitary governance to apartheid too.

[INSERT TABLE 5 HERE]

Apartheid was maintained in two ways, armed repression and the geographic isolation of Blacks in

homeland territories. Both were expensive. Table 5 reports the average annual expenditures on military,

police and justice (prison) services for the apartheid years following the 1976 Soweto massacre, generally

regarded as a defining (radicalizing) moment in majority resistance, both violent and non-violent, to the

apartheid regime. Average military spending per elite resident over this period was 3,510 Rand (�$600 2000

USD) per year. Homeland territories were rural and provided residents with only subsistence agriculture.

By 1985, two-thirds of South Africa’s Blacks lived in one of the ten homelands; the remaining third lived

on white owned farms or in the segregated townships outside the major cities. Basic public services to the

homelands were provided by subsidies from the white central government at an average annual cost per elite

resident of 2740 Rand (�$450 2000 USD) per year. Together the fiscal burden of military and homeland

spending was 6,250 Rand per year or a bit more than 7 percent of the average elite resident’s annual income

of 86,000 Rand – significant, but still a good deal less than the estimated 40 percent tax burden on elite

incomes under democratic federalism; see Table 5.

The real costs for the elite under apartheid came from the damage that international sanctions and

domestic labor unrest imposed on economic growth; see Table 5. Beginning in 1976, and motivated by the

Soweto massacre, the international community implemented a series of increasingly stringent sanctions on

imports to, and exports from, South Africa. They remained in place until the end of 1993, when the

transition and the election of President Mandela seemed assured. Their combined effect, measured by the

variable SANC (= 1 for 1976-1993; 0 otherwise), was to reduce economic growth by an average of 1.55

52 Like other country growth regressions, we find trade openness (OPEN = exports + imports as a percent of

GDP)is an important determinant of growth; Table 5, columns (2) and (3). Sanctions had a significant adverse effect

on trade openness’ Table 5 column (4). Sanctions began with the United Nations arms embargo in 1976 just after

Soweto. Beginning in 1978, the internationa l capital markets refused to make long-term loans to the apartheid

government (Waldmeir, 1997, p. 23). In 1985, Chase Manhattan Bank withdrew all short-term lending and other major

banks then followed (Waldmeir, 1997, p. 56), and the EC and the British Commonwealth countries imposed trade and

financial sanctions. In 1986, the U.S. Congress enacted the Comprehensive Anti-Apartheid Act, banning U.S.

investments and loans to South Africa and imports from South Africa. All sanctions remained in place until 1993. See

also Hufbauer, Schott, and Elliott (1990; pp. 221-248).

53 Source: South African Reserve Bank, www.reservebank.co.za, Time Series KBP6244J.

54 We consider only three regimes for South Africa since, for our calibration, the majority prefers unitary

democracy to administrative federalism as the strategic alternative to democratic federalism; see Table 4 .

42

percent per annum (Table 5, col.1).52 The channel through which sanctions lowered growth was the trade

channel; Table 5, cols.2-5. More important was the threat of domestic labor unrest measured by the

emergence in 1985 of a militant trade union federation called the Congress of South African Trade Unions

(COSATU). Over the period of COSATU militancy (= 1 for 1985-1993; 0 otherwise), economic growth fell

an additional 2.1 percent per annum (Table 5, col.1), from the joint adverse effects of labor unrest on

investment and trade (Table 5, cols. 2-5). Overall, the South African economy grew at an annual rate of 2.43

percent during the peaceful years of apartheid (1950-1975), then declined to .88 percent when only sanctions

were in force (1976-1984), and finally fell to -1.2 percent as both sanctions and COSATU discouraged trade

and investment (1985-1993). With the election of Nelson Mandela as President, growth became positive

again, achieving an average annual rate of .67 in the first six years of democracy (1994-2000). Since 2000,

we estimate the economy has been growing at an average annual rate of 2.5 percent.53 Moving from negative

growth to an annual growth rate of 2 percent or more will have sizeable long-run implications for economic

welfare. It is here that the real benefits to the elite of leaving apartheid are realized.

Table 6 computes the long-run benefits from leaving apartheid, inclusive of the net differences in

elite taxation under the three relevant regimes: apartheid, unitary democracy, and federal democracy.54 The

annual fiscal costs of apartheid have been estimated above as 6,250 Rand per year. In democracy, the annual

fiscal costs will be 32,000 Rand per elite resident from redistributive taxation under unitary governance and

55 Estimated at the time of the democratic transition. In both unitary and federal democratic equilibriums, there

will be approximately 4.8 million adult elite residents and 25 million adult majority residents. Taxes paid to the central

government by each elite resident will be 32,000 Rand to support gU and (25/4.8)@(6119) = 31,870 to support gF; see

Table 4. Under democratic federalism, however, the elite are able to capture .20 of the difference between gF and se(qFFC)

or .20@[gF - se(qFFC)][Me/N(JF)] = .20[6119 - 2494]@(4.6/4.8) = 695 Rand/Elite Resident. The net tax burden will therefore

be 31,870 - 695 = 31,175 Rand.

56 Source: Table 5. Elite population declines in post-apartheid South Africa to 4.8 million in our calibrations.

Thus, the burden elite resident becomes 8,145 Rand (= 39,100 M illion Rand/4.8 Million Elite Adults). If one views

homeland transfers as a “protection expenditure” – in effect, the cost of containing Blacks in segregated areas – then the

total costs of protection under apartheid should be measured as military spending plus homeland spending or (Table 5)

60 Billion Rand per year (= 33.7 Billion + 26 .3 Billion). In this light, democracy provides an annual “peace dividend”

of about 20.9 Billion Rand (= 60 Billion - 39.1 Billion). In our framework these funds are being allocated to

redistributive spending for the majority.

43

31,175 Rand per elite resident from redistributive taxation (net of capture) under federal governance.55 Post

apartheid, there are no homeland payments but there annual expenditures for military, police and justice

averaging 39.1 Billion (2000) Rand per year for the years 1994-2006, an additional fiscal burden on the

typical elite resident of 8,145 Rand per year.56 These higher annual fiscal burdens under democracy – 40,145

under unitary governance and 39,320 Rand under federal governance vs. 6,250 Rand under apartheid – are

eventually offset, however, by the democracy’s higher rate of economic growth. For elite residents, the

present value benefit of democracy’s growth dividend discounted at r = .03 (* = .97) just begins to dominate

the present value cost of democracy’s higher taxes after 22 years (year 2018) under unitary, and after 21

years (year 2017) under federal governance; see Table 6. Of course, the majority benefits immediately.

[INSERT TABLE 6 HERE]

For elite residents, the long-run economic welfare from the transition can be sizeable. After 70 years,

or roughly two adult generations, the net gains for a representative elite adult from leaving autocracy for

democracy ()NPV in Table 6) is 2.197 Million Rand (� $370,000 (2000) USD) under democratic federalism

and 2.179 Million Rand (� $363,000 (2000) USD) under unitary governance. The elite prefers democratic

federalism to unitary governance since by managing their own province, the elite can and does capture back

a portion of their redistributive tax payments to the central government. The internal rates of return are .118

for the transition to democratic federalism and .115 for the transition to a unitary democracy; see Table 6.

57 The keys to democracy high rate of return for South Africa was in removing international sanctions and

politically active Black unions as impediments to economic growth. Two counterfactuals are worth considering. Absent

international sanctions but assuming continued domestic political resistance by COSATU, elite net economic returns

from the transition would have only become positive in a present value sense ()NPV = 0) after 32 years from the start

of democracy. The implied internal rate of return for accepting democracy over apartheid falls to .086. Absent domestic

political resistance but assuming continued international sanctions, the elite breaks even ()NPV = 0) following the

transition only after 43 years from the start of democracy, and the internal rate of return of the transition falls further to

.063. These calculations suggest international sanctions alone might not have been enough to push white South Africa

to accept an ANC majority-run democracy. Indeed, comments by the NP leadership at the time of the transition suggest

they saw international sanctions more as a nuisance than a significant economic hardship; see Waldmeir (1997; p. 134).

44

Only elite residents with a real rate of time preference greater than 12 percent (* < .89) would have found

it rational to have rejected the transition.57

Finally, the federal form of governance is economically preferred by both the elite and majority

residents of South Africa to unitary governance; see Table 6. From the perspective of Table 1, sustainable

democratic federalism (Cell 1) is pareto preferred to its non-cooperative, strategic alternative of unitary

governance (Cells 3 or 6). From the perspective of a democratic transition, however, both forms of

governance are preferred to apartheid. We conclude, democratic federalism was a sufficient institution for

South Africa’s transition, but from an economic perspective alone, it was not a necessary institution.

VI. Concluding Remarks

Our analysis of the South African transition suggests at least four lessons for those seeking to move

from autocracy to democracy. First, a peaceful transition requires that both the old ruling elite and the new

majority willingly accept the new constitution. For elite approval, the new constitution must offer credible,

long-run protection of elite resources in a self-enforcing way, without reliance on outside military

intervention or unspecified moral suasion. We have specified the economic and demographic conditions for

when one form of governance, called democratic federalism, might successfully provide such protections.

The South African constitution provides one example and perhaps a role model for other emerging

democracies.

Second, for democracy to be attractive to autocracy’s elite, costs at least as large as democracy’s

anticipated redistributive burden must be imposed upon the elite in the autocratic regime. Those costs may

45

come from military spending to prevent a majority coup d’état, from the economic losses following majority

boycotts and strikes, or from the burden of international economic sanctions. By credibly controlling

democracy’s redistributive burden, democratic federalism lowers the threshold for required costs in autocracy

and thereby makes a peaceful transition to democracy more likely.

Third, our analysis makes clear exactly what is needed for the elite to peacefully check the

majority’s desire to impose maximal redistributive taxation in the new democratic regime. Having given up

the army, and thus the threat of a counter coup d’état, the elite needs another means to penalize the majority

if they deviate to maximal redistribution. In our analysis, that penalty is found in the elite’s ability to deny

the majority access to high productivity, low cost elite providers of important redistributive public services,

for example, education, health care, and social services. What the federal constitution provides is an

institutional structure for organizing elite providers into a blocking cartel by creating an elite province hiring

elite providers with the monopoly right to provide redistributive services to majority residents in the

province. Using provincial government has the additional advantage of providing a legal channel through

which to distribute the cartel’s captured surplus to elite residents, perhaps most plausibly as extra services

targeted to elite neighborhoods. In this way it is very useful to have the elite concentrated geographically.

An elite province created for a landed aristocracy spread throughout the country may be difficult to

administer. Practically speaking, sustainable democratic federalism may require a significant, “first-world”

urban center.

Finally, while democratic federalism can facilitate the transition to democracy, it is a fragile

constitutional form. South Africa, for example, is close to the point where the elite, as a political minority

in national politics, may no longer be able to discourage maximal redistributive taxation through its ability

to control provincial fiscal policies. Its threat to deny transfer incomes to its province’s majority residents

by a “high capture” strategy may no longer be credible. If so, the federal constitution’s protections of elite

resources will be lost and, at least with respect to redistributive economic policy, unitary governance

46

becomes the de facto constitutional form. Other than by re-capturing government through its own military

coup d’état, the elite’s only hope will be to find new political allies within the majority, perhaps as part of

new, locally based political parties or through alliances with high growth majority controlled provinces. In

this regard, our work here on federalism as a means to facilitate the democratic transition complements the

classic work by Riker (1964) and the recent analysis of de Figueiredo and Weingast (2005) on sustaining the

federal compact in established democracies.

47

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49

TABLES

TABLE 1: THE POLICY GAME

TABLE 2: RSA INTERGOVERNMENTAL TRANSFERS

TABLE 3: POLITICAL ECONOMY OF SOUTH AFRICA

TABLE 4: RSA INTERGOVERNMENTAL TRANSFERS: PREDICTED

TABLE 5: THE ECONOMIC BURDEN OF APARTHEID

TABLE 6: NET ECONOMIC GAINS FROM THE DEMOCRATIC TRANSITION

50

TABLE 1: THE POLICY GAME

MAJORITY PAYOFFS per MAJORITY CITIZEN

STRATEGIES

MAJORITY

STRATEGY F: (JF; PROV INCES > 1)

MAJORITY

STRATEGY A: (JU; PROVINCES > 1)

MAJORITY

STRATEGY U: (JU)

ELITE

STRATEGY: nL

(1)

T(F; nL) = W + gF[1 - nL@:] - sF(q) + NL@:@se(q) + 8L(q)

(2)

T(A; nL) = W + gU[1 - nL@:] - sF(q) + nL@:@se(q) +8L(q)

(3)

T(U)=W+gU-sU(q) + 8L(q)

ELITE

STRATEGY: nH

(4)

T(F; nH) = W + gF[1 - nH@:] - sF(q) + nH@:@se(q) + 8L(q)

(5)

T(A; nH) = W + gU[1-nH@:] - sF(q) + nH@:@se(q) + 8L(q)

(6)

T(U)=W+gU-sU(q)+ 8L(q)

ELITE PAYOFFS per ELITE CITIZEN

STRATEGIES

MAJORITY

STRATEGY F: (JF; PROV INCES > 1)

MAJORITY

STRATEGY A: (JU; PROV INCES > 1)

MAJORITY

STRATEGY U: (JU)

ELITE

STRATEGY: nL

(1)

y(F; nL) = Y - JF + nL@[gF - se(q)]@[M e/N(JF)]

(2)

y(A; nL) = Y - JU + nL@[gU - se(q)]@[M e/N(JU)]

(3)

y(U) = Y - JU

ELITE

STRATEGY: nH

(4)

y(F; nH) = [Y - D] - JF + nH@[gF - se(q)]@[M e/N(JF)]

(5)

y(A; nH) = [Y - D] - JU + nH@[gU - se(q)]@[M e/N(JU)]

(6)

y(U) = Y - JU

51

TABLE 2: RSA INTERGOVERNMENTAL TRANSFERS: Real (2000) Rand per Capita†

FISCAL

YEAR

All Central

Government

Revenues

gF

National Average

gF

Western Cape

se(q)

Western Cape

be

Western Cape

gF

Other

Provinces

sm(q)

Other

Provinces

bm

Other

Provinces

1995/96 4237 2189 2923 1371 1552 2119 1356 763

1996/97 3938 2030 2587 1334 1253 1978 1345 633

1997/98 (3942)* (2000)* (2424)* (1250)* (1174)* (1959)* (1332)* (627)*

1998/99 4265 2154 2206 1398 808 2149 1709 440

1999/00 4093 2108 2097 1368 729 2110 1674 436

2000/01 6636 2242 2185 1455 730 2247 1778 469

2001/02 5570 2302 2196 1494 702 2313 1826 487

2002/03 5674 2430 2254 1577 677 2448 1927 521

2003/04 5928 2640 2207 1713 494 2682 2094 588

2004/05 6495 2952 2570 1916 654 2989 2341 648

2005/06 (6787)* (3061)* (2694)* (1986)* (708)* (3096)* (2428)* (668)*

SOURCES: FY: 1995/96 to 1997/98: Financial and Fiscal Commission, The Allocation of Financial Resources Between the National andProvincial Governments: FY 1997/98, Tables 2, 3, 6b. FY 1998/99 to 2005/06: Minister of Finance, Division of Revenue Bill, Various Years,Part 4: Provincial Allocations.

52

NOTES TO TABLE 2

†COLUMN DEFINITIONS: Central Government Revenues = Total revenues per capita raised by central government taxation; gF = Totalintergovernmental transfers per capita paid to the province(s), averaged over all provinces (National Average), for the Western Cape, and forall other provinces excluding the Western Cape (Ave. Other Provinces); s(q) = Assigned service grants per capita to fund 5-17 education,primary health care services for (lower income) citizens qualifying for medical assistance, and social security grants for the elderly, disabled,and children, for the Western Cape (se(q)) and the average for all other provinces (sm(q)); and b = “basic grant” per capita to fund all otherprovincial services and is defined as b = gF - s(q).

*Data for FY 1997/98 is based upon projected grants provided in the FFC, The Allocation of Financial Resources Between the National andProvincial Governments: FY 1997/98, Table 6b. Data for FY 2005/06 are based upon projected grants provided in Minister of Finance,Division of Revenue Bill, 2004, Part 4: Provincial Allocations, Table E4.

53

TABLE 3: POLITICAL ECONOMY OF SOUTH AFRICA^

DEMOGRAPHICS and INCOMES

N0 = 9.6 Million Elite AdultsM = 25 Million Majority AdultsY = 86,000 (Real 2000) Rand/Elite AdultW = 9,700 (Real 2000) Rand/Majority Adult$ = .00015

ELITE CAPTURE:

nL = .20 (Rate of Capture per Rand of Basic Grant)nH = .85 (Rate of Capture per Rand of Basic Grant)D = 1720 (Real 2000) Rand/Elite Adult (Protest Cost if n $ nH)

REDISTRIBUTIVE SERVICE TECHNOLOGY

ae = 17 (Years of Training; Elite Public Employee)am = 14 (Years of Training; Trained Majority Public Employee)au = 10 (Years of Training; Untrained Majority Public Employee)m = .85 (Share of Majority Residents Serviced by Trained Majority)

REDISTRIBUTIVE SERVICE COSTS

S = 80,000 (Real 2000) Rand/Public Employee (Average Uniform Salary) se(q) = S/ae = (80,000/17)Aq = 4706Aq (Real 2000) Rand/Majority Adult sm(q) = S/am = (80,000/14)Aq = 5714Aq (Real 2000) Rand/Majority Adult su(q) = S/au = (80,000/10)Aq = 8000Aq (Real 2000) Rand/Majority Adult sU(q) = mAsm(q) + (1 - m)Asu(q) = 6057Aq (Real 2000) Rand/Majority Adult

SPECIAL INTEREST PAYMENTS

Z = 600 Million (Real 2000) Rand (Compensation for Lost Homeland Payments)

DISCOUNT FACTOR* = .97

UNITARY DEMOCRACY’S FISCAL POLICIES

JU = 32,000 (Real 2000) Rand/Elite Adult (Revenue Maximizing Tax)N(JU) = .5AN0 = 4.8 Million Elite Adults (Elite Adults When J = JU) gU = [JUAN(JU) - Z]/M = 6120 (Real 2000) Rand/Majority Adult (Maximal Grant)

^ Source: Data Appendix available upon request.

54

TABLE 4: RSA INTERGOVERNMENTAL TRANSFERS: PREDICTED†

(Transfers per Majority Adult Resident, Real 2000 Rand; Transfers per Capita, Real 2000 Rand††)

VALUE MAJORITY

PUNISHMENTgmin(U) gmax(U) = gF se(q

FFC) be sm(qFFC) bm

“BEST”

ESTIMAT ES*Unitary 6035; 3319 6119; 3365 2494; 1372 3625; 1993 3028; 1665 3091; 1700

† COLUMN DEFINITIONS: MAJORITY PUNISHMENT is the preferred long-run punishment strategy of the majority if the elite chooses to adopt thehigh (nH) capture strategy; gmin = minimal intergovernmental transfer per majority adult resident (per capita) that will be accepted by the majority underdemocratic federalism, where unitary democracy is the majority’s credible punishment option; gmax = Maximal intergovernmental transfer per majorityadult resident (per capita) that will be paid by the elite under democratic federalism, where unitary democracy is the majority’s credible punishmentoption; se(q

FFC) = Intergovernmental transfer per majority adult resident (per capita) required to provide the constitutionally assigned level of publicservices per majority resident in the elite province; be = Basic grant per majority adult resident (per capita) in the elite province to fund other provincialservices, defined as be = gmax - se(q

FFC); sm(qFFC) = Intergovernmental transfer per majority adult resident (per capita) required to provide the assigned levelof public services per majority resident in majority provinces; bm = Basic grant per majority adult resident (per capita) in majority provinces to fund otherprovincial services, defined as bm = gmax - sm(qFFC).

†† TRANSFERS PER CAPITA (Italics): The calibration model estimates intergovernmental transfers per majority adult resident. For purposes ofcomparisons to Table 2, intergovernmental transfers per capita are computed as (Transfers per majority adult)@(Majority Adults/Population), where(Majority Adults /Population) = (25 m./45.5m) = .55 for 2002/2003 population.

* CALIBRATION “BEST” ESTIMATES : Demographic and economic parameters as specified in Table 3. Constitutional Border Constraint: : = .184;Constitutional Assignment Constraint: qFFC = .53.

58 Source: South African Department of Information, Perskor, South Africa, Various Years.

59 Source: Development Bank of South Africa, Annual Report, Various Years.

60 Dependent variable is South Africa’s annual real rate of growth of GDP per capita. Independent variables

include: OPEN (exports plus imports as a percentage of GDP), INV (gross investment as a share of GDP), DEM (1 for

the years 1994-2000; 0 otherwise), SANC (1 for the years 1976-1993; 0 otherwise), and COSAT U (1 for the years 1985-

1993; 0 otherwise). Source: GROWTH RATE, OPEN, and INV are from the Penn World Tables, 6.1 and correspond

to the PWT variables GRGDPCH, OPENK, and KI, respectively. DEM, SAN C, and COSATU are defined in the text.

55

TABLE 5: THE ECONOMIC BURDEN OF APARTHEID

ANNUAL MILITARY, POLICE AND JUSTICE EXPENDITURES: 1977-199358

33.7 Billion (2000) Rand/Year; 3,510 Rand/Elite Adult per Year

ANNUAL HOMELAND PAYMENTS: 1985-199359

26.3 Billion (2000) Rand/Year; 2,740 Rand/Elite Adult per Year

IMPACT OF SANCTIONS AND LABOR UNREST ON GROWTH: 1950-200060

INDEPENDENT

VARIABLES

GROWTH

RATE

(1)

GROWTH

RATE

(2)

GROWTH

RATE

(3)

OPEN

(4)

INV

(5)

Constant 2.431

(.355)*

-6.938

(1.539)*

-6.933

(1.556)*

52.038

(.531)*

14.777

(.487)*

OPEN - .137

(.037)*

.140

(.040)*

- -

INV - .147

(.069)*

.137

(.085)

- -

DEM -1.765

(.818)*

- -.188

(.941)

-3.909

(1.241)*

-7.142

(1.139)*

SANC -1.554

(.659)*

- - -12.198

(.998)*

-.203

(.916)

COSATU -2.099

(.772)*

- - -5.466

(1.176)*

-6.366

(1.079)*

R2(Adj) .345 .345 .344 .869 .600

* Significant at the 5% level; standard errors within parentheses.

56

TABLE 6: NET ECONOMIC GAINS FROM THE DEMOCRATIC TRANSITION†

YEARS UNTIL)NPV $ 0

)NPV70 YEAR HORIZON

DEMOCRACY’S INTERNALRATE OF RETURN

MAJORITY

Unitary 0 367,888 Rand 4

Federal 0 375,679 Rand 4

ELITE

Unitary 22 Years 2,179,985 Rand .115

Federal 21 Years 2,197,120 Rand .118

†COLUMN DEFINITIONS: Years until )NPV $ 0 are the number of years until the net present value gains in after-tax incomes in moving from apartheid to each form

of democracy just exceeds zero. )NPV for a 70 year horizon is the net present value gains in after-tax income in moving from apartheid to each form of democracy.

Democracy’s Internal Rate of Return is defined by that discount rate where net present value of after-tax incomes under democracy are just equal to the net present value

of after-tax incomes under apartheid so that )NPV for the full 70 year horizon is just equal to 0.

SPECIFICATION OF )NPV: For majority residents , )NPV is computed as the discounted present value of the difference between after-transfer incomes under either

unitary or federal democracies and after-transfer incomes under apartheid. Annual incomes before transfers for majority residents are: WDt = W0(1 + gD)t under unitary

or federal democracy and W At = W0(1 + gA)t under apartheid, where W0 = 9,700, gD is the growth rate under democracy specified as an incremental increase from .0067

to .025 over the ten years from 1996-2005 and as .025 for all years beyond 2006 and gA = -.012; see text. The estimates of NPV for majority residents includes the income

equivalent value of receiving red istributive services in democracy, specified as qFFC = .53 as specified by the FFC for years 1996-2000 (the transition or “Mandela” years)

and then qU = .62 under unitary democracy and qANC = .65 under federal democracy for all (ANC) years thereafter. Annual transfers are set equal to actual transfers (Table

2) for the first four years of democracy (Mandela years) and then gU = 6120 and gF = 6119 thereafter. For elite residents , )NPV is computed as the discounted present

value of the difference between after-tax incomes under either unitary or federal democracies and after-tax incomes under apartheid. Annual incomes before taxation

for elite residents are: Y Dt = Y0(1 + gD)t under unitary or federal democracy and YAt = Y0(1 + gA)t under apartheid, where Y0 = 86,000 Rand and gD and gA are specified

as above. Annual (real) taxes include taxes for homeland payments under apartheid, for redistributive transfers under democracy, and for military, police, and justice

expenditures as required by both regimes (Table 5). A discount rate of .03 (* = .97) is used for the computation of )NPV.

57

FIGURES

FIGURE 1: Feasible Federalism for the q-Regime

FIGURE 2: Surplus with Administrative Federalism

FIGURE 3: Feasible Federalism for the q*-Regime